UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
----------
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended August 27, 2005
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934
Commission file number 1-11250
----------
GTECH Holdings Corporation
(Exact name of Registrant as specified in its charter)
Delaware 05-0450121
(State or other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification Number)
55 Technology Way, West Greenwich, Rhode Island 02817
(Address of Principal Executive Offices) (Zip Code)
(401) 392-1000
(Registrant's telephone number, including area code)
----------
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes [X] No [ ]
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes [X] No [ ]
Indicate by check mark whether the Registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act).
Yes [ ] No [X]
Number of shares of Registrant's Common Stock outstanding as of September 21,
2005: 125,088,626
INDEX
GTECH HOLDINGS CORPORATION AND SUBSIDIARIES
Page
Number
------
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets 3
Consolidated Income Statements 4-5
Consolidated Statements of Cash Flows 6
Consolidated Statement of Shareholders' Equity 7
Notes to Consolidated Financial Statements 8-27
Item 2. Management's Discussion and Analysis of Financial Condition 28-44
and Results of Operations
Item 3. Quantitative and Qualitative Disclosures about Market Risk 45
Item 4. Controls and Procedures 45
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 45
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 46
Item 4. Submission of Matters to a Vote of Security Holders 47
Item 6. Exhibits 48
SIGNATURES 48
EXHIBITS
PART 1. FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS
GTECH HOLDINGS CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Unaudited)
August 27, February 26,
2005 2005
----------- ------------
(Dollars in thousands)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 167,819 $ 94,446
Investment securities available-for-sale 236,175 196,825
Trade accounts receivable, net 146,310 168,706
Sales-type lease receivables 3,220 3,461
Refundable performance deposit 8,000 8,000
Inventories 64,115 61,135
Deferred income taxes 26,378 31,435
Other current assets 31,387 26,646
----------- ------------
TOTAL CURRENT ASSETS 683,404 590,654
SYSTEMS, EQUIPMENT AND OTHER ASSETS RELATING TO CONTRACTS, net 692,624 720,438
GOODWILL, net 330,954 331,022
PROPERTY, PLANT AND EQUIPMENT, net 86,772 74,558
INTANGIBLE ASSETS, net 67,283 70,839
REFUNDABLE PERFORMANCE DEPOSIT 12,000 12,000
SALES-TYPE LEASE RECEIVABLES 3,387 4,756
OTHER ASSETS 40,568 50,874
----------- ------------
TOTAL ASSETS $ 1,916,992 $ 1,855,141
=========== ============
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable $ 59,453 $ 99,234
Accrued expenses 51,298 54,227
Employee compensation 27,321 21,862
Advance payments from customers 43,880 42,865
Deferred revenue and advance billings 26,883 29,705
Income taxes payable 37,519 16,499
Taxes other than income taxes 17,390 16,572
Short term borrowings 1,842 334
Current portion of long-term debt 3,474 2,476
----------- ------------
TOTAL CURRENT LIABILITIES 269,060 283,774
LONG-TERM DEBT, less current portion 597,413 726,329
OTHER LIABILITIES 98,075 83,260
DEFERRED INCOME TAXES 98,287 106,010
COMMITMENTS AND CONTINGENCIES -- --
SHAREHOLDERS' EQUITY:
Preferred Stock, par value $.01 per share - 20,000,000 shares authorized,
none issued -- --
Common Stock, par value $.01 per share - 200,000,000 shares authorized,
123,835,495 and 116,551,144 shares issued; 123,835,495 and 115,006,751
shares outstanding at August 27, 2005 and February 26, 2005, respectively 1,238 1,166
Additional paid-in capital 390,557 278,204
Accumulated other comprehensive loss (46,842) (43,227)
Retained earnings 509,204 455,537
----------- ------------
854,157 691,680
Less cost of 1,544,393 shares in treasury at February 26, 2005 -- (35,912)
----------- ------------
854,157 655,768
----------- ------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 1,916,992 $ 1,855,141
=========== ============
See Notes to Consolidated Financial Statements
-3-
GTECH HOLDINGS CORPORATION AND SUBSIDIARIES
CONSOLIDATED INCOME STATEMENTS
(Unaudited)
Three Months Ended
-----------------------
August 27, August 28,
2005 2004
---------- ----------
(Dollars in thousands,
except per share amounts)
Revenues:
Services $ 266,341 $ 248,114
Sales of products 43,601 75,401
---------- ----------
309,942 323,515
Costs and expenses:
Costs of services 161,624 148,481
Costs of sales 24,744 43,874
---------- ----------
186,368 192,355
---------- ----------
Gross profit 123,574 131,160
Selling, general and administrative 29,838 29,889
Research and development 11,243 12,647
---------- ----------
Operating expenses 41,081 42,536
---------- ----------
Operating income 82,493 88,624
Other income (expense):
Interest income 2,105 981
Equity in earnings of unconsolidated affiliates 531 293
Other expense (638) (1,924)
Interest expense (8,005) (3,719)
---------- ----------
(6,007) (4,369)
---------- ----------
Income before income taxes 76,486 84,255
Income taxes 27,534 31,174
---------- ----------
Net income $ 48,952 $ 53,081
========== ==========
Basic earnings per share $ 0.41 $ 0.45
========== ==========
Diluted earnings per share $ 0.38 $ 0.40
========== ==========
Weighted average shares outstanding - basic 120,851 117,070
========== ==========
Weighted average shares outstanding - diluted 130,052 132,743
========== ==========
Cash dividends declared per common share $ 0.085 $ 0.085
========== ==========
See Notes to Consolidated Financial Statements
-4-
GTECH HOLDINGS CORPORATION AND SUBSIDIARIES
CONSOLIDATED INCOME STATEMENTS
(Unaudited)
Six Months Ended
-----------------------
August 27, August 28,
2005 2004
---------- ----------
(Dollars in thousands,
except per share amounts)
Revenues:
Services $ 557,705 $ 501,440
Sales of products 78,636 102,280
---------- ----------
636,341 603,720
Costs and expenses:
Costs of services 330,541 295,774
Costs of sales 46,348 59,791
---------- ----------
376,889 355,565
---------- ----------
Gross profit 259,452 248,155
Selling, general and administrative 61,857 57,524
Research and development 24,181 25,734
---------- ----------
Operating expenses 86,038 83,258
---------- ----------
Operating income 173,414 164,897
Other income (expense):
Interest income 4,150 2,316
Equity in earnings of unconsolidated affiliates 2,318 1,599
Other income (expense) (2,432) 8,601
Interest expense (15,270) (8,055)
---------- ----------
(11,234) 4,461
---------- ----------
Income before income taxes 162,180 169,358
Income taxes 58,384 62,662
---------- ----------
Net income $ 103,796 $ 106,696
========== ==========
Basic earnings per share $ 0.88 $ 0.91
========== ==========
Diluted earnings per share $ 0.80 $ 0.80
========== ==========
Weighted average shares outstanding - basic 117,748 117,848
========== ==========
Weighted average shares outstanding - diluted 129,947 133,860
========== ==========
Cash dividends declared per common share $ 0.17 $ 0.17
========== ==========
See Notes to Consolidated Financial Statements
-5-
GTECH HOLDINGS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Six Months Ended
-----------------------
August 27, August 28,
2005 2004
---------- ----------
(Dollars in thousands)
OPERATING ACTIVITIES
Net income $ 103,796 $ 106,696
Adjustments to reconcile net income to net cash provided by operating
activities:
Depreciation 83,523 68,504
Intangibles amortization 5,316 4,170
Deferred income taxes 7,000 13,904
Tax benefit related to stock award plans 6,827 6,615
Minority interest 1,264 1,518
Equity in earnings of unconsolidated affiliates, net of dividends received 205 908
Gain on sale of investments (584) (10,924)
Other 11,381 13,300
Changes in operating assets and liabilities:
Trade accounts receivable 18,626 (18,552)
Inventories (2,991) (5,255)
Accounts payable (35,900) (9,111)
Employee compensation 4,234 (15,996)
Advance payments from customers 1,015 (5,904)
Deferred revenue and advance billings (2,822) 17,700
Income taxes payable 21,009 15,664
Other assets and liabilities (6,669) (11,480)
---------- ----------
NET CASH PROVIDED BY OPERATING ACTIVITIES 215,230 171,757
INVESTING ACTIVITIES
Acquisitions (net of cash acquired) (30) (192,402)
Purchases of systems, equipment and other assets relating to contracts (59,934) (113,011)
Purchases of available-for-sale investment securities (121,675) (50,150)
Maturities and sales of available-for-sale investment securities 82,325 272,000
Purchases of property, plant and equipment (5,198) (6,359)
License fee (1,750) --
Investments in and advances to unconsolidated subsidiaries (1,000) (1,435)
(Increase) decrease in restricted cash 5,080 (5,112)
Proceeds from sale of investment 3,000 11,773
---------- ----------
NET CASH USED FOR INVESTING ACTIVITIES (99,182) (84,696)
FINANCING ACTIVITIES
Net proceeds from issuance of long-term debt -- 15,000
Principal payments on long-term debt (1,358) (92,249)
Purchases of treasury stock (32,051) (82,808)
Dividends paid (20,287) (20,135)
Premiums and fees paid in connection with the early retirement of debt -- (10,610)
Proceeds from stock options 8,431 4,966
Other 2,623 739
---------- ----------
NET CASH USED FOR FINANCING ACTIVITIES (42,642) (185,097)
Effect of exchange rate changes on cash (33) (1,036)
---------- ----------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 73,373 (99,072)
Cash and cash equivalents at beginning of period 94,446 129,339
---------- ----------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 167,819 $ 30,267
========== ==========
See Notes to Consolidated Financial Statements
-6-
GTECH HOLDINGS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY - (Unaudited)
Accumulated
Additional Other
Outstanding Common Paid-in Comprehensive Retained Treasury
Shares Stock Capital Loss Earnings Stock Total
----------- ------ ---------- ------------- -------- -------- --------
(Dollars in thousands)
Balance at February 26, 2005 115,006,751 $1,166 $ 278,204 $ (43,227) $455,537 $(35,912) $655,768
Comprehensive income:
Net income -- -- -- -- 103,796 -- 103,796
Other comprehensive income (loss),
net of tax:
Foreign currency translation -- -- -- (4,006) -- -- (4,006)
Amortization of unrecognized gain on
interest rate locks to interest
expense -- -- -- (165) -- -- (165)
Unrecognized net gain on derivative
instruments -- -- -- 481 -- -- 481
Unrealized gain on investments -- -- -- 75 -- -- 75
--------
Comprehensive income 100,181
Treasury shares purchased (1,326,100) -- -- -- -- (32,051) (32,051)
Cash dividends on common stock
($0.17 per share) -- -- -- -- (20,431) -- (20,431)
Shares issued under employee stock purchase
and stock award plans 219,612 -- 350 -- (1,234) 4,509 3,625
Shares issued upon exercise of stock options 834,585 4 4,656 -- (5,407) 9,178 8,431
Shares issued upon conversion of debentures 9,100,647 68 100,520 -- (23,057) 54,276 131,807
Tax benefits related to stock award plans -- -- 6,827 -- -- -- 6,827
----------- ------ ---------- ------------- -------- -------- --------
Balance at August 27, 2005 123,835,495 $1,238 $ 390,557 $ (46,842) $509,204 $ -- $854,157
=========== ====== ========== ============= ======== ======== ========
See Notes to Consolidated Financial Statements
-7-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
GTECH HOLDINGS CORPORATION AND SUBSIDIARIES
NOTE 1 - ORGANIZATION, BASIS OF PRESENTATION AND STOCK-BASED COMPENSATION PLANS
ORGANIZATION
GTECH Holdings Corporation ("Holdings") is a global gaming and technology
company providing software, networks and professional services that power
high-performance, transaction processing systems. We are the world's leading
operator of highly-secure online lottery transaction processing systems, doing
business in 52 countries worldwide and we have a growing presence in commercial
gaming technology and financial services transaction processing. We have a
single operating and reportable business segment, the Transaction Processing
segment. In these notes, the terms "Holdings," "Company," "we," "our," and "us"
refer to GTECH Holdings Corporation and all subsidiaries included in the
consolidated financial statements, unless otherwise specified. The accounting
policies of the Transaction Processing segment are the same as those described
in Note 1 - "Organization and Summary of Significant Accounting Policies" in our
Consolidated Financial Statements and footnotes included in our fiscal 2005
Annual Report on Form 10-K. Management evaluates the performance of this segment
based on operating income.
BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements of Holdings, the
parent of GTECH Corporation ("GTECH"), have been prepared in accordance with
generally accepted accounting principles ("GAAP") for interim financial
information and with the instructions to Form 10-Q and Article 10 of Regulation
S-X. They do not include all information and notes required by GAAP for complete
financial statements. In the opinion of management, all adjustments (consisting
of normal recurring accruals) considered necessary for a fair presentation have
been included. Operating results for the six-month period ended August 27, 2005
are not necessarily indicative of the results that may be expected for the full
fiscal year ending February 25, 2006. The balance sheet at February 26, 2005 has
been derived from the audited financial statements at that date. For further
information refer to the Consolidated Financial Statements and footnotes
included in our fiscal 2005 Annual Report on Form 10-K.
Certain amounts in our prior period financial statements have been reclassified
to conform to the current period presentation.
STOCK-BASED COMPENSATION PLANS
We follow Accounting Principles Board Opinion No. 25, "Accounting for Stock
Issued to Employees" ("APB 25") and related Interpretations in accounting for
our stock-based compensation plans and we have elected to continue to use the
intrinsic value-based method to account for stock option grants. We have adopted
the disclosure-only provisions of Statement of Financial Accounting Standards
No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure,"
an amendment of Statement of Financial Accounting Standards No. 123.
Accordingly, no compensation expense has been recognized for our stock-based
compensation plans other than for restricted stock.
-8-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 1 - ORGANIZATION, BASIS OF PRESENTATION AND STOCK-BASED COMPENSATION PLANS
(continued)
Had we elected to recognize compensation expense based upon the fair value at
the grant dates for awards under these plans, net income and earnings per share
would have been reduced to the pro forma amounts listed in the table below. In
the first and second quarters of fiscal 2005, the fair value of each grant was
estimated on the date of grant using the Black-Scholes option pricing model. In
the first and second quarters of fiscal 2006, the fair value of each grant was
estimated on the date of grant using a binomial option pricing model. We changed
our option pricing model to a binomial model as we believe the binomial model
provides a better estimate of fair value.
Three Months Ended Six Months Ended
----------------------- -----------------------
August 27, August 28, August 27, August 28,
2005 2004 2005 2004
---------- ---------- ---------- ----------
(Dollars in thousands, except per share amounts)
Net income, as reported $ 48,952 $ 53,081 $ 103,796 $ 106,696
Add: Stock-based compensation expense
included in reported net income, net of
related tax effects 694 656 2,308 1,254
Deduct: Total stock-based compensation
expense determined under the fair value
method for all awards, net of related
tax effects (1,855) (2,380) (4,606) (4,392)
---------- ---------- ---------- ----------
Pro forma net income $ 47,791 $ 51,357 $ 101,498 $ 103,558
========== ========== ========== ==========
Basic earnings per share:
As reported $ 0.41 $ 0.45 $ 0.88 $ 0.91
Pro forma 0.40 0.44 0.86 0.88
Diluted earnings per share:
As reported $ 0.38 $ 0.40 $ 0.80 $ 0.80
Pro forma 0.37 0.39 0.79 0.78
In December 2004, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 123 (revised 2004), "Share-Based
Payment" ("SFAS 123R"), which is a revision of FASB Statement No. 123,
"Accounting for Stock-Based Compensation" and supersedes APB 25. SFAS 123R
requires all share-based payments to employees, including grants of employee
stock options, be recognized in the financial statements based on their fair
values. Pro forma disclosure will no longer be an alternative. We plan to adopt
SFAS 123R on the first day of fiscal 2007 (February 26, 2006). We currently
estimate the impact of adopting SFAS 123R will be in a range of $0.04 to $0.06
per diluted share in fiscal 2007.
-9-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 2 - COMMON STOCK SPLIT
In the second quarter of fiscal 2005, our Board of Directors approved a 2-for-1
common stock split, payable in the form of a stock dividend, which entitled each
shareholder of record on July 1, 2004 to receive one share of common stock for
each outstanding share of common stock held on that date. The stock dividend was
distributed on July 30, 2004. All references to common shares and per share
amounts herein have been restated to reflect the stock splits for all periods
presented.
NOTE 3 - INVENTORIES
Inventories consist of the following:
August 27, February 26,
2005 2005
---------- ------------
(Dollars in thousands)
Raw materials $ 20,295 $ 29,622
Work in progress 29,287 15,492
Finished goods 14,533 16,021
---------- ------------
$ 64,115 $ 61,135
========== ============
Inventories include amounts we manufacture or assemble for our long-term service
contracts and amounts related to product sales contracts, including product
sales which are accounted for using contract accounting. Work in progress at
August 27, 2005 and February 26, 2005 includes approximately $23.1 million and
$12.0 million, respectively, related to product sale contracts.
Amounts received from customers in advance of revenue recognition (primarily
related to product sale contracts included in work in progress above) totaled
$43.9 million and $42.9 million at August 27, 2005 and February 26, 2005,
respectively.
NOTE 4 - RESTRICTED ASSETS
Pursuant to a June 2004 ruling (the "Ruling") in a civil action initiated by
federal attorneys with Brazil's Public Ministry, certain of our Brazilian assets
totaling approximately $10.7 million (including $5.1 million of cash that was
included in Other Assets in our Consolidated Balance Sheet at February 26,
2005), was restricted from transfer or sale. In July 2004, we filed an appeal of
the Ruling and in March 2005, an appellate court decision ordered that the
restrictions on the transfer or sale of our Brazilian assets be removed.
Accordingly, there were no restricted assets as of August 27, 2005.
-10-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 5 - PRODUCT WARRANTY
We offer a product warranty on all of our manufactured products (primarily
terminals and related peripherals) sold to our customers. Although we do not
have a standard product warranty, our typical warranty provides that we will
repair or replace defective products for a period of time (usually a minimum of
90 days) from the date revenue is recognized or from the date a product is
delivered and tested. We estimate product warranty costs that we expect to incur
during the warranty period and we record a charge to costs of sales for the
estimated warranty cost at the time the product sale is recorded. In determining
the appropriate warranty provision, consideration is given to historical
warranty cost information, the status of the terminal model in its life cycle
and current terminal performance. We periodically assess the adequacy of our
product warranty reserves and adjust them as necessary in the period when the
information necessary to make the adjustment becomes available.
We typically do not provide a product warranty on purchased products sold to our
customers but attempt to pass the manufacturer's warranty, if any, on to them.
A summary of product warranty activity for the three and six months ended August
27, 2005 and August 28, 2004 is as follows:
Three Months Ended Six Months Ended
----------------------- -----------------------
August 27, August 28, August 27, August 28,
2005 2004 2005 2004
---------- ---------- ---------- ----------
(Dollars in thousands)
Balance at beginning of period $ 1,291 $ 1,505 $ 1,634 $ 749
Additional reserves 166 480 250 561
Charges incurred (58) (786) (469) (947)
Change in estimate (434) 2 (434) (298)
Opening reserve balance associated
with acquisitions -- -- -- 1,126
Other 29 25 13 35
---------- ---------- ---------- ----------
Balance at end of period $ 994 $ 1,226 $ 994 $ 1,226
========== ========== ========== ==========
Our reserves for product warranty are included in Accrued Expenses in our
Consolidated Balance Sheets.
-11-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 6 - LONG-TERM DEBT
Long-term debt consists of the following:
August 27, February 26,
2005 2005
---------- ------------
(Dollars in thousands)
4.75% Senior Notes due October 2010 $ 249,718 $ 249,690
4.50% Senior Notes due December 2009 149,646 149,604
5.25% Senior Notes due December 2014 148,771 148,704
1.75% Convertible Debentures due
December 2021 49,866 175,000
Fair value of interest rate swaps (686) 541
Other, due through October 2007 3,572 5,266
---------- ------------
600,887 728,805
Less current portion 3,474 2,476
---------- ------------
$ 597,413 $ 726,329
========== ============
1.75% CONVERTIBLE DEBENTURES
Our 1.75% Convertible Debentures due December 2021 (the "Debentures") are
convertible at the option of the holder into shares of our common stock in
certain specified circumstances. The Debentures became convertible on May 1,
2003 and remained convertible through the end of the second quarter of fiscal
2006 (August 27, 2005) because the sale price of our common stock was more than
120% of the conversion price (approximately $16.50 per share) for at least 20
trading days in a 30 trading-day period.
During the first six months of fiscal 2006, approximately $125.1 million
principal amount of the Debentures were converted by holders of the Debentures,
resulting in the issuance of 9,100,647 shares of our common stock. After the
close of our fiscal 2006 second quarter, an additional $16.0 million principal
amount of Debentures were converted, resulting in the issuance of 1,162,398
shares of our common stock.
CREDIT FACILITY
We have a $500 million unsecured senior revolving credit facility expiring in
October 2009 (the "Credit Facility"). There were no outstanding borrowings under
the Credit Facility at August 27, 2005 or February 26, 2005. Up to $100 million
of the Credit Facility may be used for the issuance of letters of credit. At
August 27, 2005 there was $492.5 million available for borrowing under the
Credit Facility, after considering $7.5 million of letters of credit issued and
outstanding.
-12-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 7 - COMMITMENTS AND CONTINGENCIES
OPTION TO PURCHASE POLCARD OUTSTANDING EQUITY
In May 2003, we completed the acquisition of a controlling equity position in
PolCard S.A. ("PolCard"), for a purchase price, net of cash acquired, of $35.9
million. PolCard is the leading debit and credit card merchant transaction
acquirer and processor in Poland. At February 26, 2005, PolCard's outstanding
equity was owned 62.8% by us, 36.9% by two funds managed by Innova Capital Sp.
z o.o. ("Innova"), a Warsaw-based private equity investment advisor, and 0.3% by
the Polish Bank Association, one of PolCard's previous owners.
On September 28, 2005 (after the close of our fiscal 2006 second quarter), we
purchased an additional 11.681% of PolCard from Innova for cash consideration
of approximately $21.5 million.
We have three fair value options to purchase Innova's interest in PolCard, and
Innova has the reciprocal right to sell its interest in PolCard to us at fair
value. Each fair value option has a duration of 90 days and is to be based on an
appraised value from at least two investment banks at the date of each option
period.
Taking into consideration our purchase of an additional 11.681% of PolCard, we
estimate that the buyout prices of each fair value option, based on discounted
cash flows, could be as follows:
Buyout Percentage
of the PolCard Range of
Exercise Date Commencing In Outstanding Equity Buyout Price
- --------------------------- ------------------ ------------------
May 2007 12.6% $20 to $30 million
May 2008 6.3% $11 to $17 million
May 2009 6.3% $13 to $19 million
OTHER
See "Legal Proceedings" in Part II, Item 1 and "Management's Discussion and
Analysis of Financial Condition and Results of Operations" in Part I, Item 2 of
this report.
-13-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 8 - GUARANTEES AND INDEMNIFICATIONS
PERFORMANCE AND OTHER BONDS
In connection with certain contracts and procurements, we have been required to
deliver performance bonds for the benefit of our customers and bid and
litigation bonds for the benefit of potential customers, respectively. These
bonds give the beneficiary the right to obtain payment and/or performance from
the issuer of the bond if certain specified events occur. In the case of
performance bonds, which generally have a term of one year, such events include
our failure to perform our obligations under the applicable contract. To obtain
these bonds, we are required to indemnify the issuers against the costs they
incur if a beneficiary exercises its rights under a bond. Historically, our
customers have not exercised their rights under these bonds and we do not
currently anticipate that they will do so. The following table provides
information related to potential commitments at August 27, 2005:
Total potential
commitments
---------------
(in thousands)
Performance bonds $ 221,617
Financial guarantees 30,707
Litigation bonds 9,370
All other bonds 4,962
---------------
$ 266,656
===============
LOTTERY TECHNOLOGY SERVICES INVESTMENT CORPORATION
We have a 44% interest in Lottery Technology Services Corporation ("LTSC"),
which we account for using the equity method of accounting. LTSC provides
equipment and services (which we supplied to LTSC), to the Taipei Fubon Bank.
The Taipei Fubon Bank holds the license to operate the Taiwan Public Welfare
Lottery.
In fiscal 2002, we signed an agreement with Acer, Inc. ("Acer"), the partner
that holds the remaining 56% interest in LTSC, which provides that in the event
a third party lender to LTSC requires the guarantee of GTECH or Acer as a
condition of making a loan to LTSC, we, along with Acer, will provide such a
guarantee on reasonable terms. This potential guarantee is limited to 44% of any
such third-party loan and would expire on December 31, 2006.
LOTTERY TECHNOLOGY ENTERPRISES
We have a 1% interest in Lottery Technology Enterprises ("LTE"), a joint venture
between us and District Enterprise for Lottery Technology Applications of
Washington, D.C. ("DELTA"). The joint venture agreement terminates on December
31, 2012. LTE holds a 10-year contract (which expires in November 2009) with the
District of Columbia Lottery and Charitable Games Control Board. Under
Washington, D.C. law, by virtue of our 1% interest in LTE, we may be jointly and
severally liable, with DELTA, for the obligations of the joint venture.
-14-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 8 - GUARANTEES AND INDEMNIFICATIONS (continued)
ATRONIC
In December 2004, we entered into an agreement to acquire a 50% controlling
equity position in the Atronic group of companies ("Atronic") privately held by
the Gauselmann Group ("Gauselmann"). The remaining 50% of Atronic will be
retained by the owners of Gauselmann. Atronic is a video slot machine
manufacturer and also develops slot machine games and customized solutions for
dynamic gaming operations. This transaction is contingent upon regulatory and
gaming license approvals and other closing conditions, and is expected to be
completed on December 31, 2006.
On March 24, 2005, we guaranteed 50% of Atronic's obligations due under a Euro
50 million (approximately $61 million at the August 27, 2005 exchange rate) loan
made by a commercial lender to Atronic (the "Agreement"). Our maximum liability
under this guarantee is equal to the lesser of Euro 25 million (approximately
$31 million at the August 27, 2005 exchange rate) or 50% of Atronic's
outstanding obligations under the Agreement. The guarantee arose in connection
with our planned acquisition of Atronic on December 31, 2006. We would be
required to perform under the guarantee should Atronic fail to make any interest
or principal payments in accordance with the terms and conditions of the
Agreement. Our guarantee expires on April 26, 2010. As of August 27, 2005, the
carrying amount of the liability for our obligations under this guarantee is
$2.0 million, which is included in Other Liabilities in our Consolidated Balance
Sheets. A corresponding asset of $2.0 million is included in Other Assets in our
Consolidated Balance Sheets.
The Agreement stipulates that if any event of default should occur and be
continuing under our Credit Facility, we would be required to deposit in an
account with the commercial lender, Euro 25 million, which would be held by the
commercial lender as collateral for the payment and performance of our
obligations under the guarantee. The commercial lender would have control over
this account. The cash deposit would be released to us three business days after
all the events of default have been cured or waived.
LOXLEY GTECH PRIVATE LIMITED
We have a 49% interest in Loxley GTECH Private Limited Co. ("LGT"), which is
accounted for using the equity method of accounting. LGT is a corporate joint
venture that will provide the online lottery system in Thailand. On March 29,
2005, in order to assist LGT with obtaining the financing they require to enable
them to perform under their obligation to operate the online lottery system in
Thailand, we guaranteed, along with the 51% shareholder in LGT, Baht 1.925
billion (approximately $47 million at the August 27, 2005 exchange rate)
principal amount in loans and Baht 455 million (approximately $11 million at the
August 27, 2005 exchange rate) in performance bonds and trade finance facilities
made to LGT by an unrelated commercial lender (collectively, the "Facilities").
We are jointly and severally liable with the other shareholder in LGT for this
guarantee. We would be required to perform under the guarantee should LGT fail
to make interest or principal payments in accordance with the terms and
conditions of the Facilities. Our guarantee obligations commenced in July 2005
and will terminate upon the start-up of the online lottery system in Thailand,
which is currently expected to occur in the fourth quarter of fiscal 2006. As of
August 27, 2005, LGT had no borrowing under the loans. As of August 27, 2005,
the carrying amount of the liability for our obligations under this guarantee
was de minimus.
-15-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 8 - GUARANTEES AND INDEMNIFICATIONS (continued)
WORLD HEADQUARTERS FACILITY
Under our Master Contract with the State of Rhode Island, we are to invest (or
cause to be invested) at least $100 million in the State of Rhode Island, in the
aggregate, by December 31, 2008. This investment commitment includes the
development of a new world headquarters facility in Providence, Rhode Island by
December 31, 2006. We have entered into (i) a development agreement with US Real
Estate Limited Partnership (the "Developer"), whereby the Developer will develop
and own the facility; and (ii) an office lease with the Developer, whereby we
will lease a portion of the facility from the Developer for 20 years. We also
entered into (i) a 149 year ground lease with Capital Properties, Inc. (the
"Ground Landlord") with respect to the land upon which the facility will be
constructed; and (ii) a completion guarantee in favor of the Ground Landlord
whereby we guaranteed the completion of the facility and the payment of the rent
and real estate taxes under the ground lease until the completion of the
facility. We have assigned the ground lease to the Developer but remain liable
under the ground lease and the completion guarantee. Rent payable under the
ground lease is currently $0.1 million per year. It is our position that our
liability under the ground lease will expire upon completion of the facility.
Upon completion of the facility, the Ground Landlord's recourse in the event of
a default by the Developer under the ground lease is limited to the facility.
NOTE 9 - COMPREHENSIVE INCOME
The components of comprehensive income are as follows:
Three Months Ended Six Months Ended
----------------------- -----------------------
August 27, August 28, August 27, August 28,
2005 2004 2005 2004
---------- ---------- ---------- ----------
(Dollars in thousands)
Net income $ 48,952 $ 53,081 $ 103,796 $ 106,696
Other comprehensive income (loss),
net of tax
Foreign currency translation 1,082 1,954 (4,006) (266)
Amortization of unrecognized
gain on interest rate locks
to interest expense (82) -- (165) --
Unrecognized net gain (loss) on
derivative instruments (482) 513 481 1,407
Unrealized gain (loss) on
investments 75 -- 75 (2)
---------- ---------- ---------- ----------
Comprehensive income $ 49,545 $ 55,548 $ 100,181 $ 107,835
========== ========== ========== ==========
-16-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 10 - EARNINGS PER SHARE
The following table shows the computation of basic and diluted earnings per
share:
Three Months Ended Six Months Ended
----------------------- -----------------------
August 27, August 28, August 27, August 28,
2005 2004 2005 2004
---------- ---------- ---------- ----------
(In thousands, except per share amounts)
Numerator:
Net income (Numerator for basic
earnings per share) $ 48,952 $ 53,081 $ 103,796 $ 106,696
Effect of dilutive securities:
Interest expense on 1.75%
Convertible Debentures, net
of tax 277 518 801 1,047
---------- ---------- ---------- ----------
Numerator for diluted earnings per
share $ 49,229 $ 53,599 $ 104,597 $ 107,743
========== ========== ========== ==========
Denominator:
Denominator for basic earnings
per share-weighted average
shares 120,851 117,070 117,748 117,848
Effect of dilutive securities:
1.75% Convertible Debentures 6,418 12,727 9,506 12,727
Employee stock options 2,573 2,744 2,518 3,062
Unvested stock awards and
employee stock purchase plan
shares 210 202 175 223
---------- ---------- ---------- ----------
Dilutive potential common
shares 9,201 15,673 12,199 16,012
Denominator for diluted earnings
per share-adjusted weighted
average shares and assumed
conversions 130,052 132,743 129,947 133,860
========== ========== ========== ==========
Basic earnings per share $ 0.41 $ 0.45 $ 0.88 $ 0.91
========== ========== ========== ==========
Diluted earnings per share $ 0.38 $ 0.40 $ 0.80 $ 0.80
========== ========== ========== ==========
NOTE 11 - INCOME TAXES
Our effective income tax rate is greater than the statutory rate primarily due
to state income taxes. The effective income tax rate is based upon expected
income for the year, the composition of income or loss in different
jurisdictions and related statutory tax rates, accruals for tax contingencies
and the tax consequences or benefits from audits or the resolution of tax
contingencies.
In October 2004, the American Jobs Creation Act of 2004 (the "Act") was signed
into law. Among its provisions, the Act provides for a one-time special
deduction for certain qualifying dividends from foreign subsidiaries. We have
made the determination that it is not economical to repatriate foreign dividends
at this time.
-17-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 12 - SUPPLEMENTAL CASH FLOW INFORMATION
Non-cash investing and financing activities are excluded from the consolidated
statement of cash flows. Non-cash activities that occurred during the first six
months of fiscal 2006 and 2005 are summarized as follows:
August 27, August 28,
2005 2004
---------- ----------
(Dollars in thousands)
Issuance of 6,830,141 shares of Holding common
stock in connection with the conversion of
our 1.75% Convertible Debentures $ 93,915 $ --
Issuance of 2,270,506 treasury shares in
connection with the conversion of our 1.75%
Convertible Debentures 31,219 --
Non-cash investment related to our new world
headquarters facility in Providence, RI 10,386 1,351
Excess deferred tax liabilities associated with
the contingent interest feature of our 1.75%
Convertible Debentures 9,666 --
Debt issuance costs reclassified to additional
paid-in capital in connection with the
conversion of our 1.75% Convertible Debentures 3,080 --
Treasury shares issued under stock award plans 2,390 2,736
NOTE 13 - SUBSEQUENT EVENT
In September 2005, after the close of our fiscal 2006 second quarter, we
announced that we have received a non-binding preliminary expression of interest
from an unidentified third party regarding the potential acquisition of the
Company. In light of this expression of interest, the independent members of our
board of directors are examining our strategic options with the assistance of
Citigroup Global Markets as their financial advisor.
As previously announced, our board has not concluded that we should enter into
any extraordinary transaction and, in any event, there can be no assurance that,
if the directors determine that a sale of the Company at this time is an
attractive option, a transaction will be successfully negotiated or consummated,
or as to the form or terms of such a transaction.
-18-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 14 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION
On December 18, 2001, Holdings (the "Parent Company") issued, in a private
placement, $175 million principal amount of 1.75% Convertible Debentures due
December 15, 2021 (the "Debentures"). On October 9, 2003, the Parent Company
issued, in a private placement, $250 million principal amount of 4.75% Senior
Notes due October 15, 2010, and on November 16, 2004, issued $150 million
principal amount of 4.75% Senior Notes due December 1, 2009 and $150 million
principal amount of 5.25% Senior Notes due December 1, 2014 (collectively, the
"Senior Notes"). All of the Senior Notes were subsequently exchanged for Senior
Notes registered under the Securities Act of 1933. The Debentures and Senior
Notes are unsecured and unsubordinated obligations of the Parent Company that
are jointly and severally, fully and unconditionally guaranteed by GTECH and two
of its wholly owned subsidiaries: GTECH Rhode Island Corporation and GTECH Latin
America Corporation (collectively with GTECH, the "Guarantor Subsidiaries").
Condensed consolidating financial information is presented below.
Selling, general and administrative costs and research and development costs are
allocated to each subsidiary based on the ratio of the subsidiaries' combined
service revenues and sales of products to consolidated revenues.
The Parent Company conducts business through its consolidated subsidiaries and
unconsolidated affiliates and has, as its only material asset, an investment in
GTECH. Equity in earnings of consolidated affiliates recorded by the Parent
Company includes the Parent Company's share of the after-tax earnings of GTECH.
Taxes payable and deferred income taxes are obligations of the subsidiaries.
Income tax expense related to both current and deferred income taxes are
allocated to each subsidiary based on our consolidated effective income tax
rates.
-19-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 14 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION
(continued)
Condensed Consolidating Balance Sheets
August 27, 2005
Parent Guarantor Non-Guarantor Eliminating
Company Subsidiaries Subsidiaries Entries Consolidated
------------- ------------- ------------- ------------- -------------
(Dollars in thousands)
Assets
Current Assets:
Cash and cash equivalents $ -- $ 84,274 $ 83,545 $ -- $ 167,819
Investment securities available-for-sale -- 236,175 -- -- 236,175
Trade accounts receivable, net -- 78,790 67,520 -- 146,310
Due from subsidiaries and affiliates -- 57,104 -- (57,104) --
Sales-type lease receivables -- 3,033 187 -- 3,220
Refundable performance deposit -- -- 8,000 -- 8,000
Inventories -- 29,721 39,036 (4,642) 64,115
Deferred income taxes -- 12,445 13,933 -- 26,378
Other current assets -- 8,841 22,546 -- 31,387
------------- ------------- ------------- ------------- -------------
Total Current Assets -- 510,383 234,767 (61,746) 683,404
Systems, Equipment and Other Assets Relating to
Contracts, net -- 599,210 106,410 (12,996) 692,624
Investment in Subsidiaries and Affiliates 854,157 453,032 -- (1,307,189) --
Goodwill, net -- 115,981 214,973 -- 330,954
Property, Plant and Equipment, net -- 52,282 34,490 -- 86,772
Intangible Assets, net -- 20,716 46,567 -- 67,283
Refundable Performance Deposit -- -- 12,000 -- 12,000
Sales-Type Lease Receivables -- 3,338 49 -- 3,387
Other Assets -- 12,692 27,876 -- 40,568
------------- ------------- ------------- ------------- -------------
Total Assets $ 854,157 $ 1,767,634 $ 677,132 $ (1,381,931) $ 1,916,992
============= ============= ============= ============= =============
Liabilities and Shareholders' Equity
Current Liabilities:
Accounts payable $ -- $ 32,954 $ 26,499 $ -- $ 59,453
Due to subsidiaries and affiliates -- -- 57,104 (57,104) --
Accrued expenses -- 29,552 21,746 -- 51,298
Employee compensation -- 17,596 9,725 -- 27,321
Advance payments from customers -- 11,720 32,160 -- 43,880
Deferred revenue and advance billings -- 14,676 12,207 -- 26,883
Income taxes payable -- 30,685 6,834 -- 37,519
Taxes other than income taxes -- 8,822 8,568 -- 17,390
Short term borrowings -- -- 1,842 -- 1,842
Current portion of long-term debt -- -- 3,474 -- 3,474
------------- ------------- ------------- ------------- -------------
Total Current Liabilities -- 146,005 180,159 (57,104) 269,060
Long-Term Debt, less current portion -- 597,314 99 -- 597,413
Other Liabilities -- 71,002 27,073 -- 98,075
Deferred Income Taxes -- 81,518 16,769 -- 98,287
Shareholders' Equity 854,157 871,795 453,032 (1,324,827) 854,157
------------- ------------- ------------- ------------- -------------
Total Liabilities and Shareholders' Equity $ 854,157 $ 1,767,634 $ 677,132 $ (1,381,931) $ 1,916,992
============= ============= ============= ============= =============
-20-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 14 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION
(continued)
Condensed Consolidating Balance Sheets
February 26, 2005
Parent Guarantor Non-Guarantor Eliminating
Company Subsidiaries Subsidiaries Entries Consolidated
------------- ------------- ------------- ------------- -------------
(Dollars in thousands)
Assets
Current Assets:
Cash and cash equivalents $ -- $ 23,020 $ 71,426 $ -- $ 94,446
Investment securities available-for-sale -- 196,825 -- -- 196,825
Trade accounts receivable, net -- 82,212 86,494 -- 168,706
Due from subsidiaries and affiliates -- 53,345 -- (53,345) --
Sales-type lease receivables -- 3,215 246 -- 3,461
Refundable performance deposit -- -- 8,000 -- 8,000
Inventories -- 30,387 34,366 (3,618) 61,135
Deferred income taxes -- 14,030 17,405 -- 31,435
Other current assets -- 6,669 19,977 -- 26,646
------------- ------------- ------------- ------------- -------------
Total Current Assets -- 409,703 237,914 (56,963) 590,654
Systems, Equipment and Other Assets Relating to
Contracts, net -- 616,204 118,436 (14,202) 720,438
Investment in Subsidiaries and Affiliates 655,768 448,499 -- (1,104,267) --
Goodwill, net -- 115,981 215,041 -- 331,022
Property, Plant and Equipment, net -- 40,120 34,438 -- 74,558
Intangible Assets, net -- 22,157 48,682 -- 70,839
Refundable Performance Deposit -- -- 12,000 -- 12,000
Sales-Type Lease Receivables -- 4,681 75 -- 4,756
Other Assets -- 28,209 22,665 -- 50,874
------------- ------------- ------------- ------------- -------------
Total Assets $ 655,768 $ 1,685,554 $ 689,251 $ (1,175,432) $ 1,855,141
============= ============= ============= ============= =============
Liabilities and Shareholders' Equity
Current Liabilities:
Accounts payable $ -- $ 41,525 $ 57,709 $ -- $ 99,234
Due to subsidiaries and affiliates -- -- 53,345 (53,345) --
Accrued expenses -- 29,277 24,950 -- 54,227
Employee compensation -- 13,252 8,610 -- 21,862
Advance payments from customers -- 8,113 34,752 -- 42,865
Deferred revenue and advance billings -- 11,369 18,336 -- 29,705
Income taxes payable -- 11,902 4,597 -- 16,499
Taxes other than income taxes -- 7,688 8,884 -- 16,572
Short term borrowings -- -- 334 -- 334
Current portion of long-term debt -- -- 2,476 -- 2,476
------------- ------------- ------------- ------------- -------------
Total Current Liabilities -- 123,126 213,993 (53,345) 283,774
Long-Term Debt, less current portion -- 723,539 2,790 -- 726,329
Other Liabilities -- 64,035 19,225 -- 83,260
Deferred Income Taxes -- 101,266 4,744 -- 106,010
Shareholders' Equity 655,768 673,588 448,499 (1,122,087) 655,768
------------- ------------- ------------- ------------- -------------
Total Liabilities and Shareholders' Equity $ 655,768 $ 1,685,554 $ 689,251 $ (1,175,432) $ 1,855,141
============= ============= ============= ============= =============
-21-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 14 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION
(continued)
Condensed Consolidating Income Statements
Three Months Ended August 27, 2005
Parent Guarantor Non-Guarantor Eliminating
Company Subsidiaries Subsidiaries Entries Consolidated
----------- ------------ ------------- ----------- ------------
(Dollars in thousands)
Revenues:
Services $ -- $ 181,409 $ 84,932 $ -- $ 266,341
Sales of products -- 18,935 24,666 -- 43,601
Intercompany sales and fees -- 29,694 11,958 (41,652) --
------------- ------------ ------------- ----------- ------------
-- 230,038 121,556 (41,652) 309,942
Costs and expenses:
Costs of services -- 111,208 51,847 (1,431) 161,624
Costs of sales -- 9,574 15,170 -- 24,744
Intercompany cost of sales and fees -- 28,908 (1,433) (27,475) --
------------- ------------ ------------- ----------- ------------
-- 149,690 65,584 (28,906) 186,368
------------- ------------ ------------- ----------- ------------
Gross profit -- 80,348 55,972 (12,746) 123,574
Selling, general & administrative -- 19,300 10,538 -- 29,838
Research and development -- 7,282 3,961 -- 11,243
------------- ------------ ------------- ----------- ------------
Operating expenses -- 26,582 14,499 -- 41,081
------------- ------------ ------------- ----------- ------------
Operating income -- 53,766 41,473 (12,746) 82,493
Other income (expense):
Interest income -- 1,513 592 -- 2,105
Equity in earnings (loss) of
unconsolidated affiliates -- 923 (392) -- 531
Equity in earnings of
consolidated affiliates 48,952 26,076 -- (75,028) --
Other expense -- (142) (496) -- (638)
Interest expense -- (7,571) (434) -- (8,005)
------------- ------------ ------------- ----------- ------------
48,952 20,799 (730) (75,028) (6,007)
------------- ------------ ------------- ----------- ------------
Income before income taxes 48,952 74,565 40,743 (87,774) 76,486
Income taxes -- 26,843 14,667 (13,976) 27,534
------------- ------------ ------------- ----------- ------------
Net income $ 48,952 $ 47,722 $ 26,076 $ (73,798) $ 48,952
============= ============ ============= =========== ============
-22-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 14 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION
(continued)
Condensed Consolidating Income Statements
Six Months Ended August 27, 2005
Parent Guarantor Non-Guarantor Eliminating
Company Subsidiaries Subsidiaries Entries Consolidated
------------- ------------ ------------- ----------- ------------
(Dollars in thousands)
Revenues:
Services $ -- $ 371,047 $ 186,658 $ -- $ 557,705
Sales of products -- 28,032 50,604 -- 78,636
Intercompany sales and fees -- 78,171 24,574 (102,745) --
------------- ------------ ------------- ----------- ------------
-- 477,250 261,836 (102,745) 636,341
Costs and expenses:
Costs of services -- 225,392 107,750 (2,601) 330,541
Costs of sales -- 14,312 32,036 -- 46,348
Intercompany cost of sales and fees -- 57,064 6,400 (63,464) --
------------- ------------ ------------- ----------- ------------
-- 296,768 146,186 (66,065) 376,889
------------- ------------ ------------- ----------- ------------
Gross profit -- 180,482 115,650 (36,680) 259,452
Selling, general & administrative -- 38,795 23,062 -- 61,857
Research and development -- 15,165 9,016 -- 24,181
------------- ------------ ------------- ----------- ------------
Operating expenses -- 53,960 32,078 -- 86,038
------------- ------------ ------------- ----------- ------------
Operating income -- 126,522 83,572 (36,680) 173,414
Other income (expense):
Interest income -- 2,908 1,242 -- 4,150
Equity in earnings of
unconsolidated affiliates -- 2,212 106 -- 2,318
Equity in earnings of
consolidated affiliates 103,796 52,202 -- (155,998) --
Other income (expense) -- 406 (2,838) -- (2,432)
Interest expense -- (14,753) (517) -- (15,270)
------------- ------------ ------------- ----------- ------------
103,796 42,975 (2,007) (155,998) (11,234)
------------- ------------ ------------- ----------- ------------
Income before income taxes 103,796 169,497 81,565 (192,678) 162,180
Income taxes -- 61,019 29,363 (31,998) 58,384
------------- ------------ ------------- ----------- ------------
Net income $ 103,796 $ 108,478 $ 52,202 $ (160,680) $ 103,796
============= ============ ============= =========== ============
-23-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 14 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION (continued)
Condensed Consolidating Income Statements
Three Months Ended August 28, 2004
Parent Guarantor Non-Guarantor Eliminating
Company Subsidiaries Subsidiaries Entries Consolidated
----------- ------------ ------------- ----------- ------------
(Dollars in thousands)
Revenues:
Services $ -- $ 176,690 $ 71,424 $ -- $ 248,114
Sales of products -- 40,394 35,007 -- 75,401
Intercompany sales and fees -- 17,957 10,806 (28,763) --
------------ ------------ ------------- ----------- ------------
-- 235,041 117,237 (28,763) 323,515
Costs and expenses:
Costs of services -- 101,756 47,569 (844) 148,481
Costs of sales -- 20,380 23,494 -- 43,874
Intercompany cost of sales and fees -- 21,321 4,286 (25,607) --
------------ ------------ ------------- ----------- ------------
-- 143,457 75,349 (26,451) 192,355
------------ ------------ ------------- ----------- ------------
Gross profit -- 91,584 41,888 (2,312) 131,160
Selling, general & administrative -- 20,020 9,869 -- 29,889
Research and development -- 8,454 4,193 -- 12,647
------------ ------------ ------------- ----------- ------------
Operating expenses -- 28,474 14,062 -- 42,536
------------ ------------ ------------- ----------- ------------
Operating income -- 63,110 27,826 (2,312) 88,624
Other income (expense):
Interest income -- 172 809 -- 981
Equity in earnings (loss) of
unconsolidated affiliates -- 573 (280) -- 293
Equity in earnings of
consolidated affiliates 53,081 15,781 -- (68,862) --
Other income (expense) -- 1,071 (2,995) -- (1,924)
Interest expense -- (3,408) (311) -- (3,719)
------------ ------------ ------------- ----------- ------------
53,081 14,189 (2,777) (68,862) (4,369)
------------ ------------ ------------- ----------- ------------
Income before income taxes 53,081 77,299 25,049 (71,174) 84,255
Income taxes -- 28,600 9,268 (6,694) 31,174
------------ ------------ ------------- ----------- ------------
Net income $ 53,081 $ 48,699 $ 15,781 $ (64,480) $ 53,081
============ ============ ============= =========== ============
-24-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 14 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION (continued)
Condensed Consolidating Income Statements
Six Months Ended August 28, 2004
Parent Guarantor Non-Guarantor Eliminating
Company Subsidiaries Subsidiaries Entries Consolidated
------------ ------------ ------------- ----------- ------------
(Dollars in thousands)
Revenues:
Services $ -- $ 355,353 $ 146,087 $ -- $ 501,440
Sales of products -- 58,838 43,442 -- 102,280
Intercompany sales and fees -- 49,863 24,997 (74,860) --
------------ ------------ ------------- ----------- ------------
-- 464,054 214,526 (74,860) 603,720
Costs and expenses:
Costs of services -- 205,830 91,306 (1,362) 295,774
Costs of sales -- 31,748 28,056 (13) 59,791
Intercompany cost of sales and fees -- 45,017 8,577 (53,594) --
------------ ------------ ------------- ----------- ------------
-- 282,595 127,939 (54,969) 355,565
------------ ------------ ------------- ----------- ------------
Gross profit -- 181,459 86,587 (19,891) 248,155
Selling, general & administrative -- 39,462 18,062 -- 57,524
Research and development -- 17,660 8,074 -- 25,734
------------ ------------ ------------- ----------- ------------
Operating expenses -- 57,122 26,136 -- 83,258
------------ ------------ ------------- ----------- ------------
Operating income -- 124,337 60,451 (19,891) 164,897
Other income (expense):
Interest income -- 785 1,531 -- 2,316
Equity in earnings (loss) of
unconsolidated affiliates -- 1,914 (315) -- 1,599
Equity in earnings of
consolidated affiliates 106,696 44,022 -- (150,718) --
Other income (expense) -- (358) 8,959 -- 8,601
Interest expense -- (7,305) (750) -- (8,055)
------------ ------------ ------------- ----------- ------------
106,696 39,058 9,425 (150,718) 4,461
------------ ------------ ------------- ----------- ------------
Income before income taxes 106,696 163,395 69,876 (170,609) 169,358
Income taxes -- 60,456 25,854 (23,648) 62,662
------------ ------------ ------------- ----------- ------------
Net income $ 106,696 $ 102,939 $ 44,022 $ (146,961) $ 106,696
============ ============ ============= =========== ============
-25-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 14 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION (continued)
Condensed Consolidating Statements of Cash Flows
Six Months Ended August 27, 2005
Parent Guarantor Non-Guarantor Eliminating
Company Subsidiaries Subsidiaries Entries Consolidated
------------ ------------ ------------- ----------- ------------
(Dollars in thousands)
Net cash provided by operating activities $ -- $ 148,791 $ 67,666 $ (1,227) $ 215,230
Investing Activities
Acquisitions (net of cash acquired) -- -- (30) -- (30)
Purchases of systems, equipment and
other assets relating to contracts -- (46,787) (14,374) 1,227 (59,934)
Purchases of available-for-sale
investment securities -- (121,675) -- -- (121,675)
Maturities and sales of available-for-sale
investment securities -- 82,325 -- -- 82,325
Purchases of property, plant and equipment -- (4,544) (654) -- (5,198)
License fee -- -- (1,750) -- (1,750)
Investment in advances to unconsolidated
subsidiaries -- -- (1,000) -- (1,000)
Decrease in restricted cash -- -- 5,080 -- 5,080
Proceeds from sale of investment -- -- 3,000 -- 3,000
------------ ------------ ------------- ----------- ------------
Net cash used for investing activities -- (90,681) (9,728) 1,227 (99,182)
Financing Activities
Principal payments on long-term debt -- -- (1,358) -- (1,358)
Purchases of treasury stock (32,051) -- -- -- (32,051)
Dividends paid (20,287) -- -- -- (20,287)
Proceeds from stock options 8,431 -- -- -- 8,431
Intercompany capital transactions 42,672 (42,672) -- -- --
Other 1,235 (129) 1,517 -- 2,623
------------ ------------ ------------- ----------- ------------
Net cash provided by (used for)
financing activities -- (42,801) 159 -- (42,642)
Effect of exchange rate changes on cash -- 9 (42) -- (33)
------------ ------------ ------------- ----------- ------------
Increase in cash and cash equivalents -- 15,318 58,055 -- 73,373
Cash and cash equivalents at
beginning of period -- 68,956 25,490 -- 94,446
------------ ------------ ------------- ----------- ------------
Cash and cash equivalents at end of period $ -- $ 84,274 $ 83,545 $ -- $ 167,819
============ ============ ============= =========== ============
-26-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
NOTE 14 - SUPPLEMENTAL GUARANTOR/NON-GUARANTOR FINANCIAL INFORMATION (continued)
Condensed Consolidating Statements of Cash Flows
Six Months Ended August 28, 2004
Parent Guarantor Non-Guarantor Eliminating
Company Subsidiaries Subsidiaries Entries Consolidated
------------- ------------- ------------- ------------- -------------
(Dollars in thousands)
Net cash provided by operating activities $ -- $ 166,112 $ 7,380 $ (1,735) $ 171,757
Investing Activities
Acquisitions (net of cash acquired) -- -- (192,402) -- (192,402)
Purchases of systems, equipment and other
assets relating to contracts -- (99,433) (15,313) 1,735 (113,011)
Purchases of available-for-sale investment
securities -- (50,150) -- -- (50,150)
Maturities and sales of available-for-sale
investment securities -- 272,000 -- -- 272,000
Purchases of property, plant and equipment -- (6,293) (66) -- (6,359)
Investment in advances to unconsolidated
subsidiaries -- -- (1,435) -- (1,435)
Increase in restricted cash -- -- (5,112) -- (5,112)
Proceeds from sale of investment -- -- 11,773 -- 11,773
------------ ------------ ------------ ----------- ------------
Net cash provided by (used for) investing
activities -- 116,124 (202,555) 1,735 (84,696)
Financing Activities
Net proceeds from issuance of long-term
debt -- 15,000 -- -- 15,000
Principal payments on long-term debt -- (90,000) (2,249) -- (92,249)
Purchases of treasury stock (82,808) -- -- -- (82,808)
Dividends paid (20,135) -- -- -- (20,135)
Premiums and fees paid in connection with
the early retirement of debt -- (10,610) -- -- (10,610)
Proceeds from stock options 4,966 -- -- -- 4,966
Intercompany capital transactions 97,177 (265,177) 168,000 -- --
Other 800 (61) -- -- 739
------------ ------------ ------------ ----------- ------------
Net cash provided by (used for) financing
activities -- (350,848) 165,751 -- (185,097)
Effect of exchange rate changes on cash -- (288) (748) -- (1,036)
------------ ------------ ------------ ----------- ------------
Decrease in cash and cash equivalents -- (68,900) (30,172) -- (99,072)
Cash and cash equivalents at beginning
of period -- 68,956 60,383 -- 129,339
------------ ------------ ------------ ----------- ------------
Cash and cash equivalents at end of period $ -- $ 56 $ 30,211 $ -- $ 30,267
============ ============ ============ =========== ============
-27-
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
The following Management's Discussion and Analysis ("MD&A") is intended to help
the reader understand the financial results of GTECH Holdings Corporation. MD&A
is provided as a supplement to, and should be read in conjunction with, our
financial statements and the accompanying notes. This overview provides guidance
on the individual sections of MD&A as follows:
- - FORWARD-LOOKING STATEMENTS - cautionary information about forward-looking
statements.
- - OUR BUSINESS - a general description of our business; our growth strategy;
and Brazil matters.
- - COMMON STOCK SPLIT - information about our prior year common stock split.
- - OPERATIONS REVIEW - an analysis of our consolidated results of operations
for the three and six month periods ended August 27, 2005 and August 28,
2004 presented in our financial statements. We operate in one business -
Transaction Processing, and we have a single operating and reportable
business segment. Therefore, our discussions are not quantified by segment
results.
- - LIQUIDITY, CAPITAL RESOURCES AND FINANCIAL POSITION - an analysis of cash
flows; financial position; and commitments.
- - FINANCIAL RISK MANAGEMENT AND DIVIDEND POLICY - information about financial
risk management; interest rate market risk; equity price risk; foreign
currency exchange rate risk; and our dividend policy.
Unless specified otherwise, we use the terms "Holdings," "the Company," "we,"
"our," and "us" in MD&A to refer to GTECH Holdings Corporation and its
consolidated subsidiaries included in the consolidated financial statements.
FORWARD-LOOKING STATEMENTS
Certain statements contained or incorporated by reference in this report are
forward-looking statements within the meaning of the United States Private
Litigation Reform Act of 1995. We identify forward-looking statements by words
such as "may," "will," "should," "could," "expect," "plan," "anticipate,"
"intend," "believe," "estimate," "continue," "project" or similar terms that
refer to the future. Such statements include, without limitation, statements
relating to:
- - the future prospects for and stability of the lottery industry and other
businesses in which we are engaged or expect to be engaged;
- - our future operating and financial performance (including, without
limitation, expected future growth in revenues, profit margins and earnings
per share);
- - our ability to secure and protect trademarks and other intellectual
property rights;
- - our ability to retain existing contracts and to obtain and retain new
contracts;
- - competition in the online lottery industry and other businesses in which we
are engaged or may engage and the impact of competition on our revenues and
profitability;
- - our ability to realize the anticipated benefits of our acquisitions; and
- - the results and effects of legal proceedings and investigations.
-28-
These forward-looking statements reflect management's assessment based on
information currently available, but are not guarantees and are subject to risks
and uncertainties that could cause actual results to differ materially from
those contemplated in the forward-looking statements. These risks and
uncertainties include, among other things, the following:
- - government regulations and other actions affecting the online lottery
industry could have a negative effect on our business and sales;
- - we may be subject to adverse determinations in legal proceedings (including
previously announced legal proceedings in Brazil) which could result in
substantial monetary judgments or reputational damage;
- - our lottery operations are dependent upon our continued ability to retain
and extend our existing contracts and win new contracts;
- - slow growth or declines in sales of online lottery goods and services could
lead to lower revenues and cash flows;
- - we derive over half of our revenues from foreign jurisdictions (including
over 7.4% in fiscal 2005 from Brazilian operations) and are subject to the
economic, political and social instability risks of doing business in
foreign jurisdictions;
- - our results of operations are exposed to foreign currency exchange rate
fluctuations which could result in lower revenues, net income and cash
flows when such results are translated into U.S. dollar accounts;
- - we have a concentrated customer base and the loss of any of our larger
customers (or lower sales from any of these customers) could lead to lower
revenue;
- - our quarterly operating results may fluctuate significantly, including as a
result of variations in the amount and timing of product sales, the
occurrence of large jackpots in lotteries (which increase the amount
wagered and our revenue) and expenses incurred in connection with lottery
start-ups;
- - we operate in a highly competitive environment and increased competition
may cause us to experience lower cash flows or to lose contracts;
- - we are subject to substantial penalties for failure to perform under our
contracts;
- - we may not be able to respond to technological changes or to satisfy future
technology demands of our customers in which case we could fall behind our
competitors;
- - if we are unable to manage potential risks related to acquisitions, our
business and growth prospects could suffer;
- - expansion of the gaming industry faces opposition which could limit our
access to some markets;
- - our business prospects and future success depend upon our ability to
attract and retain qualified employees;
- - our business prospects and future success rely heavily upon the integrity
of our employees and executives and the security of our systems;
- - our dependence on certain suppliers creates a risk of implementation delays
if the supply contract is terminated or breached, and any delays may result
in substantial penalties;
- - our non-lottery ventures, which are an increasingly important aspect of our
business, may fail; and
- - other risks and uncertainties set forth below and elsewhere in this report,
in our fiscal 2005 Annual Report on Form 10-K, and in our subsequent press
releases and Forms 10-Qs and other reports and filings with the Securities
and Exchange Commission.
The foregoing list of important factors is not all-inclusive.
-29-
OUR BUSINESS
GENERAL
We operate on a 52-week or 53-week fiscal year ending on the last Saturday in
February and fiscal 2006 is a 52-week year that ends on February 25, 2006.
We are a global gaming and technology company providing software, networks and
professional services that power high-performance, transaction processing
systems. We are the world's leading operator of highly-secure online lottery
transaction processing systems, doing business in 52 countries worldwide and we
have a growing presence in commercial gaming technology ("Gaming Solutions") and
financial services transaction processing ("Commercial Services"). A comparison
of our revenue concentration is as follows:
* Six Months
Ended
August 27, Fiscal Fiscal
Consolidated Revenues 2005 2005 2004
- --------------------- ---------- ---------- ----------
Lottery 85% 87% 91%
Commercial Services 10% 7% 7%
Gaming Solutions 5% 6% 2%
---------- ---------- ----------
100% 100% 100%
========== ========== ==========
Being a global business, we derive a substantial portion of our revenue from our
operations outside of the United States. In particular, in fiscal 2005, we
derived 52.2% of our revenues from international operations, including 7.4% of
our revenues from our Brazilian operations alone (including 7.2% of our revenues
from Caixa Economica Federal, the operator of Brazil's National Lottery, our
second largest customer in fiscal 2005 based on annual revenues). In addition,
substantial portions of our assets, primarily consisting of equipment we use to
operate online lottery systems for our customers, are held outside of the United
States. We are also exposed to more general risks of international operations,
including increased governmental regulation of the online lottery industry in
the markets where we operate; exchange controls or other currency restrictions;
and significant political instability.
Our service revenues are derived primarily from lottery service contracts, which
are typically at least five to seven years in duration for the base contract
term with three to five years of extension options resulting in total contract
lives of eight to ten years. Our contracts generally provide compensation to us
based upon a percentage of a lottery's gross online and instant ticket sales.
These percentages vary depending on the size of the lottery and the scope of
services provided to the lottery. We primarily derive product sale revenues from
the installation of new online lottery systems, installation of new software and
sales of lottery terminals and equipment in connection with the expansion of
existing lottery systems. Our product margins fluctuate depending on the mix,
volume and timing of product sale contracts. Our product sale revenues from
period to period may not be comparable due to the size and timing of product
sale transactions. During fiscal 2006, we currently anticipate that product
sales will be in the range of $190 million to $210 million.
Our compensation under lottery service contracts is typically based upon a
percentage of a lottery's gross online and instant ticket sales. Over the past
several fiscal years, we have experienced and may continue to experience a
reduction in the percentage of lottery ticket sales we receive from certain
customers resulting from contract rebids, extensions and renewals due to a
number of factors, including the substantial growth of lottery sales over the
last decade, reductions in the cost of technology and telecommunications
services, and general market and competitive dynamics. In anticipation and
response to these trends, beginning in fiscal 2001, we began the implementation
of our new Enterprise Series-led technology strategy combined with the
implementation of a number of ongoing cost savings initiatives and efficiency
improvement programs designed to enable us to maintain our market leadership
-30-
in the lottery industry. In addition, we are developing a suite of new lottery
games designed to maintain a strong level of same store sales growth for our
customers.
Our business is highly regulated, and the competition to secure new government
contracts is often intense. In addition, our ability to consummate the
acquisition, which we announced in December 2004, of a 50% controlling equity
interest in the Atronic group of companies, one of the world's five largest
manufacturers of slot machines, and to otherwise expand our business in
non-lottery gaming markets, is contingent upon obtaining required gaming
licenses. From time to time, competitors challenge our contract awards and there
have been, and may continue to be, investigations of various types, including
grand jury investigations conducted by government authorities into possible
improprieties and wrongdoing in connection with efforts to obtain and/or the
awarding of lottery contracts and related matters. Because such investigations
frequently are conducted in secret, we may not necessarily know of the existence
of an investigation which might involve us. Because our reputation for integrity
is an important factor in our business dealings with lottery, gaming licensing,
and other governmental agencies, a governmental allegation or a finding of
improper conduct on our part or attributable to us in any manner could have a
material adverse effect on our business, including our ability to retain
existing contracts, obtain new or renewal contracts and to expand our business
in non-lottery gaming markets. In addition, continuing adverse publicity
resulting from these investigations and related matters could have a material
adverse effect on our reputation and business. See the following for further
information concerning these matters and other contingencies:
- "Legal Proceedings" in Part II, Item 1 in this report;
- Part I, Item 1 - "Certain Factors That May Affect Future Performance -
Government regulations and other actions affecting the online lottery
industry could have a negative effect on our business and sales" in
our fiscal 2005 Annual Report on Form 10-K;
- Part I, Item 3 - "Legal Proceedings" in our fiscal 2005 Annual Report
on Form 10-K; and
- Note 14 to the Consolidated Financial Statements in our fiscal 2005
Annual Report on Form 10-K.
GROWTH STRATEGY
Fiscal 2005 was a year of significant strategic progress for us with the
acquisition of three privately-held companies that strengthened our growth
strategy in Commercial Services and Gaming Solutions. In addition, our growth
strategy in Gaming Solutions was significantly advanced when in December 2004,
we signed an agreement to acquire a 50% controlling equity position in the
Atronic group of companies, a video slot machine manufacturer that also develops
slot machine games and customized solutions for dynamic gaming operations.
Our Commercial Services market includes the processing and transmission of
commercial, non-lottery transactions including debit and credit card
transactions (both acquiring and issuing processing), bill payments, electronic
tax payments, prepaid utility payments and prepaid cellular telephone recharges.
Currently, our networks in Brazil, Poland, Chile, the Czech Republic, Jamaica
and other countries process debit and credit card transactions, bill payments
and other commercial services transactions. In the near term, we expect to
concentrate our efforts to grow commercial services revenues principally in
Central and Eastern Europe and other selected emerging economies, with the goal
of leveraging our existing technology, infrastructure and relationships to drive
growth in Commercial Services.
In addition, we will continue to identify and evaluate a variety of selective
opportunities for acquisitions in the Lottery, Commercial Services, and Gaming
Solutions markets, as well as investing in growth through licensing when the
right opportunities present themselves.
-31-
BRAZIL MATTERS
GTECH Brasil Ltda., our Brazilian subsidiary ("GTECH Brazil"), has provided
online lottery services and technology to Caixa Economica Federal ("CEF"), the
Brazilian bank and operator of Brazil's National Lottery since 1997. Revenues
from our lottery contract with CEF accounted for 7.2% of our total fiscal 2005
revenues, making CEF our second largest customer in fiscal 2005 based upon
annual revenues.
In June 2004, a ruling (the "Ruling") in a civil action initiated by federal
attorneys with Brazil's Public Ministry had the effect in fiscal 2005 of
materially reducing payments that we otherwise would have received from our
lottery contract with CEF. The Ruling ordered that 30% of payments subsequent to
the date of the Ruling due to GTECH Brazil by CEF, be withheld and deposited in
an account maintained by the Court. As of February 26, 2005, the total amount
withheld and deposited pursuant to the Ruling was approximately 68 million
Brazilian reals, or $26 million. In fiscal 2005, we did not recognize service
revenues for the payments that were withheld from GTECH Brazil, as realization
of these amounts was not reasonably assured.
In July 2004, we filed an appeal of the Ruling and in March 2005, an appellate
court decision ordered that the withholding be discontinued and that all funds
currently held in escrow in excess of 40 million Brazilian reals be returned to
us, which amounts to $11 million of the $26 million withheld as of February 26,
2005. We received and recognized these funds as service revenue on April 13,
2005. In addition, the Ruling's restrictions on the transfer or sale of our
Brazilian assets was removed and accordingly, there were no restricted cash
balances as of August 27, 2005.
The Ruling also put in place certain restrictions on the transfer or sale of
certain of our Brazilian assets. Such restrictions were lifted in March 2005.
See Note 4 of this report for further information.
In May 2005, GTECH Brazil entered into a new one-year contract with CEF, which
expires in May 2006. Foreign currency translation related to our operations in
Brazil of $56.4 million (which is recorded in Accumulated Other Comprehensive
Loss in our Consolidated Balance Sheet at August 27, 2005), would be recorded as
a charge to our consolidated income statement upon the expiration of our
contract with CEF should we determine that the expiration of the CEF contract
results in a substantial liquidation of our investment in Brazil.
Refer to Note 14 to the Consolidated Financial Statements in our fiscal 2005
Annual Report on Form 10-K for detailed disclosures regarding Brazil matters.
COMMON STOCK SPLIT
In the second quarter of fiscal 2005, our Board of Directors approved a 2-for-1
common stock split, payable in the form of a stock dividend, which entitled each
shareholder of record on July 1, 2004 to receive one share of common stock for
each outstanding share of common stock held on that date. The stock dividend was
distributed on July 30, 2004. All references to common shares and per share
amounts herein have been restated to reflect the stock splits for all periods
presented.
-32-
OPERATIONS REVIEW
COMPARISON OF THE THREE MONTH PERIODS ENDED AUGUST 27, 2005 AND AUGUST 28, 2004
REVENUES AND GROSS MARGIN
Three Months Ended
-------------------------------------------------
Change
August 27, August 28, -----------------------
2005 2004 $ %
---------- ---------- ---------- ----------
(Dollars in millions)
Domestic lottery $ 139.2 $ 129.2 $ 10.0 7.8
International lottery 90.3 91.2 (0.9) (1.0)
Commercial services 28.7 19.4 9.3 47.9
Gaming solutions 8.1 7.6 0.5 6.6
All other -- 0.7 (0.7) (100.0)
---------- ---------- ---------- ----------
Services $ 266.3 $ 248.1 $ 18.2 7.3
Sales of products 43.6 75.4 (31.8) (42.2)
---------- ---------- ---------- ----------
Total revenues $ 309.9 $ 323.5 $ (13.6) (4.2)
========== ========== ========== ==========
Three Months Ended
-------------------------------------------
Change
August 27, August 28, -----------------
2005 2004 Percentage Points
---------- ---------- -----------------
Service gross margin 39.3% 40.2% (0.9)
Product gross margin 43.2% 41.8% 1.4
The 7.8% increase in domestic lottery service revenues was primarily due to
higher revenues from an increase in sales by our domestic lottery customers of
approximately 3%, combined with net contract wins of approximately 5% (including
the impact of our new service contract in Florida and the loss of the Colorado
contract), and the benefit of the new instant ticket vending machine contract in
Illinois. These increases were partially offset by lower jackpot activity. We
believe that in general, increases in sales by our domestic lottery customers
are attributable to enhanced marketing efforts by state lottery authorities
seeking to offset declining tax revenues and the successful introduction by
state lottery authorities of new games and products, modifications to existing
games (such as matrix changes and more frequent drawings) and expanded
distribution channels, such as Keno.
International lottery service revenues decreased by 1.0%. Contractual rate
changes and lower revenues resulting from the loss of the Puerto Rico contract
combined to result in a decrease of approximately 14%. This decrease was
partially offset by favorable foreign exchange rates of approximately 6%, higher
service revenues from an increase in sales by our international lottery
customers of 3.5%, and higher revenues from Brazil related to the court ordered
cessation of withholding of approximately 2%. We believe that in general,
increases in sales by our international lottery customers are attributable to
more rapid growth rates typical of newer lottery jurisdictions, the successful
introduction of new games and modifications to existing games (such as matrix
changes and more frequent drawings).
The 47.9% increase in commercial transaction processing service revenues was
primarily due to higher revenues from Brazil related to the court ordered
cessation of withholding of approximately 23%, favorable foreign exchange rates
of approximately 21%, higher service revenues from an increase in sales by our
commercial transaction processing customers of approximately 12%, and a full
quarter of service revenues from BillBird, which we acquired in the third
quarter of last year. These increases were partially offset by contractual rate
changes.
-33-
The principal driver of the 6.6% increase in gaming solutions service revenues
was higher service revenues from an increase in sales by our gaming solutions
customers in Rhode Island and New York.
Our service margins were down 0.9 percentage points from last year, primarily
due to the loss of the Puerto Rico contract.
Product sales were down principally due to the prior year sale of lottery
terminals to our customer in Belgium. Our product margins fluctuate depending on
the mix, volume and timing of product sales contracts and were up 1.4 percentage
points from last year, primarily due to the mix of sales.
OPERATING EXPENSES
Operating expenses are comprised of selling, general and administrative (SG&A)
expenses and research and development (R&D) expenses.
Three Months Ended
-----------------------------------------------
Change
August 27, August 28, ---------------------
2005 2004 $ %
---------- ---------- --------- ---------
(Dollars in millions)
SG&A expenses $ 29.8 $ 29.9 $ (0.1) (0.3)
R&D expenses 11.2 12.6 (1.4) (11.1)
---------- ---------- --------- ---------
$ 41.0 $ 42.5 $ (1.5) (3.5)
========== ========== ========= =========
PERCENTAGE OF TOTAL REVENUE
SG&A expenses 9.6% 9.2%
R&D expenses 3.6% 3.9%
The $1.4 million decrease in R&D expenses was principally due to the timing of
development initiatives.
OTHER INCOME (EXPENSE)
The components of other income (expense) in the second quarters of fiscal 2006
and fiscal 2005 are as follows:
Three Months Ended
-----------------------------------------------
Change
August 27, August 28, ---------------------
2005 2004 $ %
---------- ---------- --------- ---------
(Dollars in millions)
Brazil financial lending tax $ (1.4) $ -- $ (1.4) (100.0)
Minority interest in
consolidated subsidiaries -- (1.1) 1.1 100.0
Foreign exchange loss (0.1) (0.8) 0.7 87.5
Gain on sale of investment 0.6 -- 0.6 100.0
Other 0.3 -- 0.3 100.0
---------- ---------- --------- ---------
$ (0.6) $ (1.9) $ 1.3 68.4
========== ========== ========= =========
The $1.4 million Brazil financial lending tax represents the accrual for a tax
assessment made during our second quarter related to intercompany loans made to
us by our Brazilian subsidiary.
The $0.6 million gain on sale of investment resulted from the sale of our 33%
interest in Turfway Park to Harrah's Entertainment and the Keeneland Association
for $3.0 million.
Minority interest in consolidated subsidiaries in the prior year principally
relates to our controlling interests in PolCard S.A. ("PolCard") and Wireless
Business Solutions (Proprietary) Limited ("WBS"). PolCard is the leading debit
and credit card merchant transaction acquirer and processor in Poland. WBS is a
telecommunications provider in South Africa.
-34-
INTEREST EXPENSE
Three Months Ended
-----------------------------------------------
Change
August 27, August 28, ---------------------
2005 2004 $ %
---------- ---------- -------- ----------
(Dollars in millions)
Interest expense $ 8.0 $ 3.7 $ 4.3 >100.0
Interest expense was up over last year primarily due to higher average debt
balances resulting from the issuance of $300 million of Senior Notes in November
2004.
INCOME TAXES
Our effective income tax rate of 36% in the second quarter of fiscal 2006 was
down from 37% in the second quarter of fiscal 2005 primarily due to a larger
percentage of international profits taxed at rates that are lower than the U.S.
statutory income tax rate. Our aggregate income tax rate in foreign
jurisdictions is lower than our income tax rate in the United States. Our income
tax rate may vary, however, depending on the composition of income or loss in
different countries and the resolution of audits and tax contingencies.
In October 2004, the American Jobs Creation Act of 2004 (the "Act") was signed
into law. Among its provisions, the Act provides for a one-time special
deduction for certain qualifying dividends from foreign subsidiaries. We have
determined that it is not economical to repatriate foreign dividends at this
time.
WEIGHTED AVERAGE DILUTED SHARES
Weighted average diluted shares in the second quarter of fiscal 2006 decreased
by 2.7 million shares to 130.1 million shares, primarily due to treasury share
repurchases made under our share buyback program.
COMPARISON OF THE SIX MONTH PERIODS ENDED AUGUST 27, 2005 AND AUGUST 28, 2004
REVENUES AND GROSS MARGIN
Six Months Ended
-----------------------------------------------
Change
August 27, August 28, ---------------------
2005 2004 $ %
---------- ---------- -------- ----------
(Dollars in millions)
Domestic lottery $ 282.3 $ 257.3 $ 25.0 9.7
International lottery 198.7 189.7 9.0 4.7
Commercial services 60.6 39.8 20.8 52.3
Gaming solutions 16.1 13.1 3.0 22.9
All other -- 1.5 (1.5) (100.0)
---------- ---------- -------- ----------
Services $ 557.7 $ 501.4 $ 56.3 11.2
Sales of products 78.6 102.3 (23.7) (23.2)
---------- ---------- -------- ----------
Total revenues $ 636.3 $ 603.7 $ 32.6 5.4
========== ========== ======== ==========
Six Months Ended
-------------------------------------------
Change
August 27, August 28, -----------------
2005 2004 Percentage Points
---------- ---------- -----------------
Service gross margin 40.7% 41.0% (0.3)
Product gross margin 41.1% 41.5% (0.4)
-35-
The principal drivers of the 9.7% increase in domestic lottery service revenues
was higher revenues from an increase in sales by our domestic lottery customers
of approximately 4%, net contract wins of approximately 3% (including the impact
of our new service contract in Florida and the loss of the Colorado contract),
and the benefit of the new instant ticket vending machine contract in Illinois.
The 4.7% increase in international lottery service revenues was primarily due to
favorable foreign exchange rates of approximately 7%, an increase in sales by
our international lottery customers of approximately 4%, and higher revenues
from Brazil of approximately 4% related to the combined impact of the court
ordered return of funds previously held in escrow and the cessation of
withholding. These increases were partially offset by the combined effect of
contractual rate changes and lower revenues from the loss of the Puerto Rico
contract.
The 52.3% increase in commercial transaction processing service revenues was
primarily due to favorable foreign exchange rates of approximately 22%, higher
revenues from Brazil of approximately 20% related to the combined impact of the
court ordered return of funds previously held in escrow and the cessation of
withholding, higher service revenues from an increase in sales by our commercial
transaction processing customers of approximately 12%, and a full six months of
service revenues from BillBird, which we acquired in the third quarter of last
year. These increases were partially offset by contractual rate changes.
The principal drivers of the 22.9% increase in gaming solutions service revenues
was a full six months of service revenues from Spielo (versus four months in the
prior fiscal year) and the installation of additional video lottery terminals in
the state of Rhode Island, along with higher service revenues from an increase
in sales by our gaming solutions customers of approximately 7%.
Our service margins were down 0.3 percentage points from last year primarily due
to the current year impact of higher depreciation and amortization related to
the implementation of new contracts, partially offset by higher margins from
Brazil related to higher service revenues resulting from the court ordered
return of funds previously held in escrow.
Product sales were down principally due to the prior year sale of lottery
terminals to our customer in Belgium. Our product margins were down 0.4
percentage points from last year, primarily due to the mix of sales.
OPERATING EXPENSES
Operating expenses are comprised of selling, general and administrative (SG&A)
expenses and research and development (R&D) expenses.
Six Months Ended
----------------------------------------------
Change
August 27, August 28, --------------------
2005 2004 $ %
---------- ---------- --------- --------
(Dollars in millions)
SG&A expenses $ 61.9 $ 57.5 $ 4.4 7.7
R&D expenses 24.1 25.7 (1.6) (6.2)
---------- ---------- --------- --------
$ 86.0 $ 83.2 $ 2.8 3.4
========== ========== ========= ========
PERCENTAGE OF TOTAL REVENUE
SG&A expenses 9.7% 9.5%
R&D expenses 3.8% 4.3%
The $4.4 million increase in SG&A expenses was principally due to increased
activities in new business development and a full six months of spending by
Spielo (versus four months of spending in the prior fiscal year). The $1.6
million decrease in R&D expenses was principally due to the timing of
development initiatives, partially offset by a full six months of spending by
Spielo.
-36-
OTHER INCOME (EXPENSE)
The components of other income (expense) in the first six months of fiscal 2006
and fiscal 2005 are as follows:
Six Months Ended
--------------------------------------------------
Change
August 27, August 28, ------------------------
2005 2004 $ %
---------- ---------- ---------- -----------
(Dollars in millions)
Brazil financial lending tax $ (1.4) $ -- $ (1.4) (100.0)
Minority interest in
consolidated subsidiaries (1.3) (1.5) 0.2 13.3
Foreign exchange loss (0.7) (0.2) (0.5) (>100.0)
Gain on sale of investment 0.6 10.9 (10.3) (94.5)
Other 0.4 (0.6) 1.0 >100.0
---------- ---------- ---------- -----------
$ (2.4) $ 8.6 $ (11.0) (>100.0)
========== ========== ========== ===========
The $1.4 million Brazil financial lending tax represents the accrual for a tax
assessment made during our second quarter related to intercompany loans made to
us by our Brazilian subsidiary.
The current year $0.6 million gain on sale of investment resulted from the sale
of our 33% interest in Turfway Park to Harrah's Entertainment and the Keeneland
Association. The prior year $10.9 million gain on sale of investment resulted
from the sale of our 50% interest in Gaming Entertainment (Delaware) L.L.C. to
Harrington Raceway, Inc.
Minority interest in consolidated subsidiaries principally relates to our
controlling interests in PolCard and WBS.
INTEREST EXPENSE
Six Months Ended
--------------------------------------------------
Change
August 27, August 28, -------------------------
2005 2004 $ %
---------- ---------- ---------- -----------
(Dollars in millions)
Interest expense $ 15.3 $ 8.1 $ 7.2 88.9
Interest expense increased over last year primarily due to higher average debt
balances resulting from the issuance of $300 million of Senior Notes in November
2004.
WEIGHTED AVERAGE DILUTED SHARES
Weighted average diluted shares in the first six months of fiscal 2006 decreased
by 3.9 million shares to 129.9 million shares, primarily due to treasury share
repurchases made under our share buyback program.
-37-
LIQUIDITY, CAPITAL RESOURCES AND FINANCIAL POSITION
We believe our ability to generate cash from operations to reinvest in our
business is one of our fundamental financial strengths and we expect to meet our
financial commitments and operating needs in the foreseeable future. We expect
to use cash generated from operating activities primarily for contractual
obligations and to pay dividends. We expect our growth to be financed through a
combination of cash generated from operating activities, existing sources of
liquidity, access to capital markets and other sources of capital. Our debt
ratings of Baa1 from Moody's and BBB from Standard and Poor's contribute to our
ability to access capital markets at attractive prices.
On September 12, 2005, we announced that our board of directors was examining
the Company's strategic options after receiving a non-binding preliminary
expression of interest from an unidentified third party regarding a potential
acquisition of our Company. Following this announcement, both Moody's and
Standard and Poor's placed our ratings on negative outlook.
ANALYSIS OF CASH FLOWS
During the first six months of fiscal 2006, we generated $215.2 million of cash
from operations. This cash was principally used to fund $59.9 million of
systems, equipment and other assets relating to contracts; to repurchase $32.1
million, or 1,326,100 shares of our common stock; and to pay cash dividends of
$20.3 million. At August 27, 2005, we had $167.8 million of cash and cash
equivalents and $236.2 million of short-term investment securities on hand.
Our business is capital-intensive. We currently estimate that net cash to be
used for investing activities in fiscal 2006 will be in the range of $190
million to $200 million. We expect our principal sources of liquidity to be
existing cash and short-term investment securities balances, along with cash we
generate from operations and borrowings under our revolving credit facility. Our
credit facility provides for an unsecured revolving line of credit of $500
million and matures in October 2009. There were no borrowings under the credit
facility as of August 27, 2005. Up to $100 million of the Credit Facility may be
used for the issuance of letters of credit. As of August 27, 2005, after
considering $7.5 million of letters of credit issued and outstanding, there was
$492.5 million available for borrowing under the credit facility. The credit
facility contains various covenants, including among other things, requirements
relating to the maintenance of certain financial ratios. None of these covenants
are expected to impact our liquidity or capital resources. There are no
covenants in our credit facility that restrict our ability to pay dividends. At
August 27, 2005, we were in compliance with all applicable covenants.
We currently expect that our cash flow from operations, existing cash, available
borrowings under our credit facility and access to additional sources of capital
will be sufficient, for the foreseeable future, to fund our anticipated working
capital and ordinary capital expenditure needs, to service our debt obligations,
to fund anticipated internal growth, to fund all or a portion of the cash needed
for potential acquisitions, to pay dividends, to fund the capital requirements
under our Master Contract with the Rhode Island Lottery and to repurchase shares
of our common stock, from time to time, under our share repurchase program. We
may also seek alternative sources of financing to fund certain of our
obligations under our Master Contract with the Rhode Island Lottery and to fund
future potential acquisitions and growth opportunities that are not currently
contemplated in our planned investing activities in fiscal 2006.
-38-
FINANCIAL POSITION
Our consolidated balance sheet as of August 27, 2005 as compared to our
consolidated balance sheet as of February 26, 2005 was impacted by the material
changes described below.
As of
------------------------- Change
August 27, February 26, -----------------
2005 2005 $ %
---------- ------------ ------- -------
(Dollars in millions)
Trade accounts receivable, net $ 146.3 $ 168.7 $ (22.4) (13.3)
Property, plant and
equipment, net 86.8 74.6 12.2 16.4
Other assets 40.6 50.9 (10.3) (20.2)
Accounts payable 59.5 99.2 (39.7) (40.0)
Income taxes payable 37.5 16.5 21.0 >100.0
Long-term debt 597.4 726.3 (128.9) (17.7)
Other liabilities 98.1 83.3 14.8 17.8
Cost of treasury shares -- 35.9 (35.9) (100.0)
The decrease in trade accounts receivable, net was primarily due to collections
of prior year receivables from product sales to our customers in Spain and
California, along with the timing of cash collections at PolCard, partially
offset by the sale of instant ticket vending machines to Pennsylvania.
The increase in property, plant and equipment, net was primarily due to $10.4
million of spending by the developer of our new corporate headquarters building
in Providence, Rhode Island.
The decrease in other assets was primarily due to the reclassification to cash
of $5.1 million of Brazil restricted cash, along with the reclassification to
shareholders' equity of $3.1 million of debt issuance costs related to the
conversion of $125.1 million of convertible debentures in the first six months
of fiscal 2006.
The decrease in accounts payable was primarily due to the timing of PolCard's
settlement of card related transactions, along with payments to the vendor that
supplied the handheld lottery terminals for our current year product sale to our
customer in Spain.
The increase in income taxes payable was primarily due to the timing of income
tax payments.
The decrease in long-term debt was principally due to the conversion to equity
of $125.1 million of our convertible debentures in the first six months of
fiscal 2006.
The increase in other liabilities was primarily due to $10.4 million of spending
by the developer of our new corporate headquarters building in Providence, Rhode
Island, along with the recognition of a $2.0 million liability associated with
the Atronic loan guarantee.
The decrease in the cost of treasury shares was primarily due to the issuance of
treasury shares in connection with the conversion of convertible debentures in
the first six months of fiscal 2006.
-39-
COMMITMENTS
PERFORMANCE AND OTHER BONDS
In connection with certain contracts and procurements, we have been required to
deliver performance bonds for the benefit of our customers and bid and
litigation bonds for the benefit of potential customers, respectively. These
bonds give the beneficiary the right to obtain payment and/or performance from
the issuer of the bond if certain specified events occur. In the case of
performance bonds, which generally have a term of one year, such events include
our failure to perform our obligations under the applicable contract. To obtain
these bonds, we are required to indemnify the issuers against the costs they
incur if a beneficiary exercises its rights under a bond. Historically, our
customers have not exercised their rights under these bonds and we do not
currently anticipate they will do so. The following table provides information
related to potential commitments at August 27, 2005:
Total Potential
Commitments
---------------
(in millions)
Performance bonds $ 221.6
Financial guarantees 30.7
Litigation bonds 9.4
All other bonds 4.9
---------------
$ 266.6
===============
MASTER CONTRACT WITH THE RHODE ISLAND LOTTERY
In May 2003, we entered into a Master Contract with the Rhode Island Lottery
(the "Lottery") that amends our existing contracts with the Lottery and grants
us the right to be the exclusive provider of online, instant ticket and video
lottery central systems and services for the Lottery during the 20-year term of
the Master Contract for a $12.5 million up-front license fee which we paid in
July 2003. Under the terms of the Master Contract, we are to invest (or cause to
be invested) at least $100 million in the State of Rhode Island, in the
aggregate, by December 31, 2008. We currently plan to satisfy our obligation to
invest (or cause to be invested) at least $100 million in the State of Rhode
Island by December 31, 2008 as follows:
- - approximately $24 million was invested during fiscal 2004;
- - approximately $15 million was invested during fiscal 2005;
- - approximately $39 million will be invested during fiscal 2006; and
- - the balance will be invested during fiscal 2007.
The Lottery may terminate the Master Contract in the event that we fail to meet
our obligations as stated above.
In addition, in July 2003 we entered into a tax stabilization agreement with the
City of Providence (the "City"), whereby the City agreed to stabilize the real
estate and personal property taxes payable in connection with our new world
headquarters facility in the City for 20 years. We also agreed to complete and
occupy the facility by December 31, 2006, employ 500 employees at the facility
by 2009, and we made certain commitments regarding our employment, purchasing
and education activities in the City.
-40-
ACQUISITION OF ATRONIC
In the fourth quarter of fiscal 2005, we entered into an agreement to acquire a
50% controlling equity position in the Atronic group of companies ("Atronic")
privately held by the Gauselmann Group ("Gauselmann"). The remaining 50% of
Atronic will be retained by the owners of Gauselmann. Atronic is a video slot
machine manufacturer and develops slot machine games and customized solutions
for dynamic gaming operations.
The final purchase price for Atronic will be calculated through a
performance-based formula equal to eight times Atronic's EBITDA (earnings before
interest, taxes, depreciation and amortization) for its fiscal year ending
December 31, 2006. In addition, in the 12 months after the closing, Atronic will
also have the potential to receive an earn-out amount based on its 2007
performance above specified thresholds. We currently expect the all-cash
transaction will have a total value of approximately $100 million to $150
million, for our 50% share, including the assumption of debt.
Beginning in 2012, we have the option to purchase Gauselmann's interest in
Atronic and Gauselmann has a reciprocal right to sell its interest to us at a
value determined by independent appraisers. There are also mutual put/call
rights that may become effective before 2012, under certain circumstances. The
exercise price under these circumstances will be calculated through a
performance based formula. This transaction is contingent upon regulatory and
gaming license approvals and other closing conditions, and is expected to be
completed on December 31, 2006.
OPTION TO PURCHASE POLCARD OUTSTANDING EQUITY
In May 2003, we completed the acquisition of a controlling equity position in
PolCard S.A. ("PolCard"), for a purchase price, net of cash acquired, of $35.9
million. PolCard is the leading debit and credit card merchant transaction
acquirer and processor in Poland. At February 26, 2005, PolCard's outstanding
equity was owned 62.8% by us, 36.9% by two funds managed by Innova Capital Sp. z
o.o. ("Innova"), a Warsaw-based private equity investment advisor, and 0.3% by
the Polish Bank Association, one of PolCard's previous owners.
On September 28, 2005 (after the close of our fiscal 2006 second quarter), we
purchased an additional 11.681% of PolCard from Innova for cash consideration of
approximately $21.5 million.
We have three fair value options to purchase Innova's interest in PolCard, and
Innova has the reciprocal right to sell its interest in PolCard to us at fair
value. Each fair value option has a duration of 90 days and is to be based on an
appraised value from at least two investment banks at the date of each option
period.
Taking into consideration our purchase of an additional 11.681% of PolCard, we
estimate that the buyout prices of each fair value option, based on discounted
cash flows, could be as follows:
Buyout Percentage
of the PolCard Range of
Exercise Date Commencing In Outstanding Equity Buyout Price
- --------------------------- ------------------ ------------------
May 2007 12.6% $20 to $30 million
May 2008 6.3% $11 to $17 million
May 2009 6.3% $13 to $19 million
-41-
FINANCIAL RISK MANAGEMENT AND DIVIDEND POLICY
FINANCIAL RISK MANAGEMENT
The primary market risk inherent in our financial instruments and exposures is
the potential loss arising from adverse changes in interest rates and foreign
currency exchange rates. Our exposure to commodity price changes is not
considered material and is managed through our procurement and sales practices.
We use various techniques to manage our market risks, including from time to
time, the use of derivative instruments. We manage our exposure to counterparty
credit risk by entering into financial instruments with major, financially sound
counterparties with high-grade credit ratings and by limiting exposure to any
one counterparty. We do not engage in currency or interest rate speculation.
INTEREST RATE MARKET RISK
Interest rate market risk is estimated as the potential change in the fair value
of our total debt or current earnings resulting from a hypothetical 10% adverse
change in interest rates.
The estimated fair value of our long-term debt and change in the estimated fair
value due to hypothetical changes in interest rates are as follows (dollars in
millions):
Estimated Fair Value
-------------------------------------------------
At August 27, 10% Increase in 10% Decrease in
2005 Interest Rates Interest Rates
------------- --------------- ---------------
$250 million of 4.75% Senior Notes $ 247.3 $ 246.1 $ 248.5
$150 million of 4.50% Senior Notes 148.2 146.2 150.3
$150 million of 5.25% Senior Notes 149.5 145.9 153.1
$50 million of 1.75% Convertible Debentures 105.5 105.4 105.5
The estimated fair values above were determined by an independent investment
banker and take into consideration $225 million of interest rate swaps as
follows:
Estimated Fair Value
-------------------------------
Debt Fair Interest Rate
Value Swaps Outstanding
--------- -----------------
$250 million of 4.75% Senior Notes $ 247.3 $ 150.0
$150 million of 4.50% Senior Notes 148.2 50.0
$150 million of 5.25% Senior Notes 149.5 25.0
A hypothetical 10% adverse or favorable change in interest rates applied to
variable rate debt would not have a material effect on current earnings.
We use various techniques to mitigate the risk associated with future changes in
interest rates, including entering into interest rate swap and treasury rate
lock agreements.
-42-
EQUITY PRICE RISK
The estimated fair value of our $50 million of 1.75% Convertible Debentures (the
"Debentures") and change in the estimated fair value due to hypothetical changes
in the market price of our common stock is as follows (dollars in millions):
Estimated Fair Value
-------------------------------------------------
10% Increase in 10% Decrease in
At August 27, Market Price of Market Price of
2005 Common Stock Common Stock
------------- --------------- ---------------
$50 million of 1.75%
Convertible Debentures $ 105.5 $ 115.8 $ 96.2
The estimated fair value above was determined by an independent investment
banker and was based on a quoted market price of $2,115.00 per Debenture.
After the close of our fiscal 2006 second quarter,approximately $16.0 million
principal amount of the Debentures were converted by holders of the Debentures.
FOREIGN CURRENCY EXCHANGE RATE RISK
We are subject to foreign exchange exposures arising from current and
anticipated transactions denominated in currencies other than our functional
currency, which is United States dollars, and from the translation of foreign
currency balance sheet accounts into United States dollar balance sheet
accounts.
We seek to manage our foreign exchange risk by securing payment from our
customers in United States dollars, by sharing risk with our customers, by
utilizing foreign currency borrowings, by leading and lagging receipts and
payments, and by entering into foreign currency exchange and option contracts.
In addition, a significant portion of the costs attributable to our foreign
currency revenues are payable in the local currencies. In limited circumstances,
but whenever possible, we negotiate clauses into our contracts that allow for
price adjustments should a material change in foreign exchange rates occur.
From time to time, we enter into foreign currency exchange and option contracts
to reduce the exposure associated with certain firm commitments, variable
service revenues and certain assets and liabilities denominated in foreign
currencies, but we do not engage in foreign currency speculation. These
contracts generally have maturities of 12 months or less and are regularly
renewed to provide continuing coverage throughout the year.
As of August 27, 2005, we had contracts for the sale of approximately $36.7
million of foreign currency (primarily Brazilian real and Euro) and the purchase
of approximately $59.2 million of foreign currency (primarily New Taiwan
dollars, Canadian dollars, Brazilian real, and pounds sterling).
At August 27, 2005, a hypothetical 10% adverse change in foreign exchange rates
would result in a translation loss of $17.6 million that would be recorded in
the equity section of our balance sheet.
At August 27, 2005, a hypothetical 10% adverse change in foreign exchange rates
would result in a net pre-tax transaction loss of $4.0 million that would be
recorded in current earnings after considering the effects of foreign exchange
contracts currently in place.
At August 27, 2005, a hypothetical 10% adverse change in foreign exchange rates
would result in a net reduction of cash flows from anticipatory transactions
during the remainder of fiscal 2006 of $13.0 million, after considering the
effects of foreign exchange contracts currently in place. The percentage of
fiscal 2006 anticipatory cash flows that were hedged varied throughout the first
six months of the fiscal year, but averaged 11%.
-43-
DIVIDEND POLICY
We are committed to returning value to our shareholders. Beginning in the second
quarter of fiscal 2004, we commenced paying cash dividends on our common stock
of $0.085 per share, equivalent to a full-year dividend of $0.34 per share. We
currently plan to continue paying dividends in the foreseeable future.
SUBSEQUENT EVENT
In September 2005, after the close of our fiscal 2006 second quarter, we
announced that we have received a non-binding preliminary expression of interest
from an unidentified third party regarding the potential acquisition of the
Company. In light of this expression of interest, the independent members of our
board of directors are examining our strategic options with the assistance of
Citigroup Global Markets as their financial advisor.
As previously announced, our board has not concluded that we should enter into
any extraordinary transaction and, in any event, there can be no assurance that,
if the directors determine that a sale of the Company at this time is an
attractive option, a transaction will be successfully negotiated or consummated,
or as to the form or terms of such a transaction.
-44-
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
See "Financial Risk Management and Dividend Policy" above.
Item 4. CONTROLS AND PROCEDURES
We carried out an evaluation, under the supervision and with the participation
of our management, including our Chief Executive Officer ("CEO") and our Senior
Vice President and Chief Financial Officer ("CFO"), of the effectiveness of our
disclosure controls and procedures (as defined in Exchange Act Rule 13a-15 (e))
as of the end of the period covered by this report. Based upon that evaluation,
our CEO and CFO concluded that our disclosure controls and procedures were
effective as of the end of the period covered by this report.
PART II. OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS
For information respecting certain legal proceedings, see Item 1, "Certain
Factors That May Affect Future Performance," Item 7, "Management's Discussion
and Analysis of Financial Condition and Results of Operations," and Item 8, Note
14 to Notes to Consolidated Financial Statements of our fiscal 2005 Annual
Report on Form 10-K.
-45-
Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
Holders of our 1.75% Convertible Debentures, due December 2021 (the
"Debentures"), have the right to convert the Debentures into shares of our
Common Stock pursuant to the terms of an Indenture, dated as of December 18,
2001.
Specifically, the Debentures are convertible at the option of the holders of the
Debentures into shares of our Common Stock at an initial conversion rate of
72.7272 shares of Common Stock per $1,000 principal amount of Debentures, which
is equivalent to an initial conversion price of approximately $13.75 per share,
subject to certain adjustments, in the following circumstances: (i) if the sale
price of our Common Stock is more than 120% of the conversion price
(approximately $16.50 per share) for at least 20 trading days in a 30
trading-day period prior to the date of surrender for conversion; (ii) if,
during any period, the credit ratings assigned to the Debentures by Moody's or
Standard & Poor's are reduced below Ba1 or BB, respectively, or the credit
rating assigned to the Debentures is suspended or withdrawn by either rating
agency; (iii) if the Debentures have been called for redemption; or (iv) upon
the occurrence of specified corporate transactions.
During our fiscal 2006 second quarter, we issued shares of our Common Stock upon
the exercise of conversion rights by Holders of the Debentures, in the amounts,
for consideration and pursuant to conversion notices dated, as follows:
Consideration (Dollars of Retired
Date of Notice of Conversion Debenture Principal Amount) Common Shares Issued
- ---------------------------- --------------------------------- --------------------
June 3, 2005 $ 5,000 363
June 21, 2005 9,263,000 673,672
June 22, 2005 7,544,000 548,654
June 23, 2005 49,400,000 3,592,727
June 24, 2005 32,528,000 2,365,672
June 30, 2005 53,000 3,854
July 12, 2005 7,500,000 545,454
July 13, 2005 11,056,000 804,071
July 14, 2005 4,097,000 297,962
This information was previously included in Current Reports on Forms 8-K except
as to transactions which related to (when aggregated with other transactions
since the last Current Report) less than 1% of the number of shares of Common
Stock outstanding.
We claim exemption from registration under the Securities Act of 1933, as
amended (the "Securities Act") in respect to the issuance of shares of Common
Stock upon the conversion of the Debentures by virtue of compliance (on the
basis of facts described herein) with Section 3(a)(9) of the Securities Act.
We made no purchases of shares of our Common Stock during the second quarter of
fiscal 2006. We have authority remaining under the stock buy-back program that
we announced in November 2004 to purchase up to $47.3 million of our Common
Stock.
-46-
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
(a) and (c)
The Company's Annual Meeting of Shareholders was held on August 1, 2005 and in
connection therewith, proxies were solicited by management pursuant to
Regulation 14A under the Securities Exchange Act of 1934. An aggregate of
114,545,219 shares of the Company's common stock ("Shares") were issued and
eligible to vote at the meeting. At the meeting, the following matters (not
including ordinary procedural matters) were submitted to a vote of the holders
of Shares, with the results indicated below:
1. Election of three directors to serve until the 2008 Annual Meeting
------------------------------------------------------------------
The following incumbent directors were reelected. The tabulation of votes was as
follows:
Nominee For Withheld
- ----------------------- ------------------ -----------------
Paget L. Alves 103,342,614 Shares 995,445 Shares
The Rt. Hon. Sir Jeremy 103,346,713 Shares 991,346 Shares
Hanley, KCMG
Anthony Ruys 55,721,142 Shares 48,616,917 Shares
2. Ratification of Ernst & Young LLP, Independent Certified Public
---------------------------------------------------------------
Accountants, as auditors for the fiscal year ending February 25, 2006
---------------------------------------------------------------------
The tabulation of votes was as follows:
For Against Abstentions
- ----------------------- ------------------ -----------------
103,011,460 Shares 1,292,975 Shares 33,624 Shares
-47-
Item 6. EXHIBITS
The exhibits to this report are as follows:
10.1 Amended and Restated Employment Agreement, dated August 2, 2005, by
and among GTECH Holdings Corporation ("Holdings"), GTECH Corporation
and W. Bruce Turner
10.2 Form of Director Indemnification Agreement, dated as of August 10,
2005, between Holdings and, respectively, each of Robert M. Dewey,
Jr., Paget L. Alves, Christine Cournoyer, Burnett W. Donoho, Sir
Jeremy Hanley, Philip R. Lochner, Jr., James F. McCann and Anthony
Ruys (incorporated by reference to Exhibit 99(a) of Holdings' Current
Report on Form 8-K filed on August 12, 2005)
12.1 Computation of Ratio of Earnings to Fixed Charges
31.1 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of
2002, of W. Bruce Turner, President and Chief Executive Officer of the
Company
31.2 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of
2002, of Jaymin B. Patel, Senior Vice President and Chief Financial
Officer of the Company
32.1 Certification Pursuant to 18 United States Code Section 1350, as
Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, of
W. Bruce Turner, President and Chief Executive Officer of the Company
32.2 Certification Pursuant to 18 United States Code Section 1350, as
Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, of
Jaymin B. Patel, Senior Vice President and Chief Financial Officer of
the Company
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
GTECH HOLDINGS CORPORATION
Date: October 4, 2005 By /s/ Jaymin B. Patel
----------------------------------------
Jaymin B. Patel, Senior
Vice President and Chief Financial
Officer (Principal Financial Officer)
Date: October 4, 2005 By /s/ Robert J. Plourde
----------------------------------------
Robert J. Plourde, Vice President,
Corporate Controller and Chief
Accounting Officer
(Principal Accounting Officer)
-48-